Corporate bonds

Definition

Corporate bonds are debt securities issued by corporations to raise capital, representing a loan made by an investor to the corporation. Investors in corporate bonds receive periodic interest payments, known as coupon payments, and are repaid the principal amount at maturity. These bonds are important because they provide corporations with necessary funding while giving investors a potentially higher return compared to government bonds.

5 Must Know Facts For Your Next Test

1. Corporate bonds can vary widely in terms of credit quality, with investment-grade bonds considered lower risk and high-yield (junk) bonds carrying a higher risk of default.
2. The interest rate on corporate bonds is typically higher than that of government bonds due to the increased risk associated with lending to corporations.
3. Corporate bonds can be secured or unsecured; secured bonds are backed by specific assets of the company, while unsecured bonds rely solely on the creditworthiness of the issuer.
4. The maturity period for corporate bonds can range from a few years to several decades, affecting both their yield and market volatility.
5. Investors may also consider callable corporate bonds, which give the issuer the right to redeem the bond before its maturity date, potentially affecting yield expectations.

Review Questions

• How do corporate bonds differ from government bonds in terms of risk and return?
  • Corporate bonds typically offer higher yields than government bonds due to the greater default risk associated with lending to corporations. While government bonds are generally considered safer investments backed by the full faith and credit of the government, corporate bonds may have varying credit ratings based on the financial health of the issuing company. This difference means that while investors can earn more from corporate bonds, they must also assess the additional risks involved.
• Discuss how credit ratings influence the pricing and yield of corporate bonds.
  • Credit ratings play a crucial role in determining the pricing and yield of corporate bonds. Bonds with higher credit ratings typically have lower yields because they are perceived as lower risk, while lower-rated or junk bonds must offer higher yields to attract investors willing to take on greater default risk. As ratings change due to a corporation's financial performance or economic conditions, bond prices can fluctuate significantly, reflecting changes in perceived risk and investor sentiment.
• Evaluate the impact of interest rate changes on corporate bond investment strategies and returns.
  • Interest rate changes can significantly impact corporate bond investment strategies and returns. When interest rates rise, existing bond prices tend to fall since new issues may offer higher yields, creating an inverse relationship. Investors might adjust their strategies by favoring shorter-duration bonds to reduce interest rate risk or considering high-yield options during rising rates to maintain attractive returns. This dynamic requires investors to constantly evaluate market conditions and adjust their portfolios accordingly to optimize returns while managing risks.

Related terms

credit rating: An assessment of the creditworthiness of a borrower, typically expressed as a letter grade, indicating the likelihood that the borrower will default on their debt obligations.

yield to maturity: The total return anticipated on a bond if it is held until it matures, taking into account both the bond's current market price and its coupon payments.

default risk: The risk that a borrower will be unable to make the required payments on their debt obligations, leading to potential financial losses for investors.