Coupon Accepted Successfully!


Corporate Bonds


  • A corporate bond is a debt instrument that obligates the issuer to pay an indicated percentage of the bond’s face value on designated dates and repay the bond’s face value at maturity
  • In the event that either the interest or principal payments are not paid, the bond is in default
  • Bondholders have a higher priority for the issuing company’s income over preferred and common shareholders
  • In the United States, corporate bonds are issued in denominations of $1,000 and multiples thereof
  • Indenture is a contract that states the promises of the corporate bond issuer and the rights of the bond holder
  • As the indenture is hard to interpret, a third party called the Trustee is introduced
  • The basic functions of a trustee are:
    • To authenticate the bonds issued; the trustees keep a record of all the bonds sold and ensure they do not exceed the principal amount stated in the indenture
    • The trustees ensure that the issuing firm adheres to all the covenants of the bond’s indenture

Interest Payment Classifications

  • There are a variety of bonds based on the interest payment characteristics:
  • Straight Coupon Bonds: These are also known as fixed-rate bonds. The interest rate received on these bonds is called the coupon. Most straight coupon bonds pay interest semiannually. For example, for a 6% coupon rate bond with a face value of $1000 would pay $30 every six months
  • Some bonds, known as participating bonds, receive payments that are greater than the coupon. These payments depend on the profits of the issuer
  • Income bonds pay coupon interest if earnings of the issuing company are sufficient. It is not mandatory. Failures to pay interest or the principal of these bonds do not indicate a default
  • Zero Coupon bonds are bonds without coupon payments. They only have a principal payment at maturity. These bonds are issued at a discount to par. The difference between the face value and the issue price of the bond is known as the Original-Issue Discount (OID)
  • Deferred Interest Bonds (DIBs), generally issued by non-investment grade companies, don’t need to pay interest for the first several years and then pay semi-annually till maturity
  • Pay In Kind (PIK) Bonds are similar to DIBs but rather than accreting the original discount, additional pieces of the same security are issued

Interest Payment Classifications

  • Floating Rate Bonds:  The interest payments by these bonds are computed in reference to a reference rate such as the 6- month LIBOR. The issuer may add a spread to the LIBOR
  • Collateralized Corporate Bonds
  • Mortgage Bonds: A mortgage bond grants the holder a first-mortgage lien on its property. This means, if the mortgage payments are not made timely, the bond holder has the right to sell the property. The underlying real estate property is the collateral for the bond
  • Collateral Trust Bonds: In case a company wants to issue bonds but does not have a fixed asset or property base, it can pledge securities of other companies which it owns
  • Equipment Trust Certificates: A Bond issued by railway companies where the collateral is cars and locomotives is an example of Equipment Trust Certificates (ETCs). This method of financing is called rolling stock
  • Debenture Bonds: Debenture bonds are unsecured bonds. Most corporate bond issues are debentures. They are traded at higher yields than secured debt
  •  Debenture bonds however, have a general claim on the assets of the issuer that are not pledged specifically to secure other debt. Debenture bonds are issued by companies who have strong credit ratings
  • Convertible Debentures give the bondholder the right to convert the debenture into common stock

Retiring of Corporate Bonds before Maturity

  • Retiring of Corporate Bonds before Maturity
  • Corporate bonds can broadly be retired before maturity in two ways namely those mechanisms that are included in the bond’s indenture and those that are not included in the bond’s indenture. The methods included in the bonds indenture are:
  • Call and refunding provision
  • Sinking Funds
  • Maintenance and Replacement Funds
  • Redemption through sale of assets
  • A method not indicated in the bond’s indenture is the fixed-spread tender offers.
  • Call and Refunding Provisions
  • The right that the issuer has to buy back the bonds in whole or part before maturity is known as a call provision. A bondholder would demand a higher yield to buy a callable bond, all else equal.
  • Callable Bond Cost = Option Free Bond Cost + Value of Embedded Option

Methods for retiring bonds

  • Fixed Price Call Provision
  • The fixed price a bond can be called at its call price. Normally, a bond’s indenture would contain a call price schedule that typically starts at a high premium above par and converges to par at maturity
  • Bondholders can be protected from a call in one of two ways:
  • Some bonds cannot be callable for the first few years
  • Some bonds prohibit the issue to be refunded (at a lower cost) for the first few years – non-refundable bonds
  • Make-Whole Call Provision
  • The call price is not fixed in this provision. The call price is determined as the present value of cash flows at a particular discount rate. This discount rate would be the yield on a comparable maturity Treasury bond with a spread. This spread is known as the make-whole call premium
  • There are two ways to arrive at the Treasury bond yield:
  • Using the Constant-Maturity Treasury rate, published weekly by the FED, for a maturity closest to that of the issue or a linear interpolation of these rates. This is a more common method
  • The yield of a treasury that has similar maturity as that of the issue. The selection of this bond would be a primary US Treasury dealer mentioned in the bond indenture


Methods for retiring bonds

  • Sinking Fund Provision:  Bonds are retired periodically rather than retiring the entire issue at maturity. The terms for the sinking fund would be mentioned in the indenture
  • For example, if $20 Million is the notional principal for a bond with a 20 year maturity, the sinking fund provision may state to retire $5 Million every 5 years
  • From a bondholder’s perspective there are two advantages of a sinking fund provision:
  • Reduced default risk
  • Bond price increases near retirement dates as a result of excess demand because of the issuer buying bonds in the open market
  • However the sinking fund provision can be a disadvantage to the bondholder if their bond is to be retired when bonds are selling above par in the market
  • An accelerated sinking fund provision is when the issuer is granted the right to retire more bonds than indicated. This reduces the bondholder’s call protection
  • Maintenance and Replacement Fund is mainly used by electric utilities companies. These companies retire their bonds for the maintenance and repair of the pledged collateral
  • The tender offer method of retiring bonds is one that is not specified in the bond’s indenture. In this method, a firm sends a tender offer and announces its aim of buying back its debt issue. The firm sends a circular to all the bond holders stating the price at which it is willing to pay for the security

Credit Risk

  • Credit Default Risk : The uncertainty whether the issuer can pay interest and principal payments in a timely manner
  • Credit Spread Risk:  A credit spread is the difference between a bond’s yield and the yield of a comparable maturity benchmark of a Treasury security
    • Credit spread risk is the risk of a loss in the value of a bond from changes in the level of credit spreads used in the marking to market
    • Factors affecting credit spread risk:
    • Macroeconomic factors
      • Level and slope of treasury yield curve
      • Business cycle
      • Consumer confidence
    • Issue-Specific factors
      • Corporation’s financial position
      • Future prospects of the firm and its industry
    • A measure of credit spread risk is spread duration. Spread duration is the change in the value of a bond for 1% change in credit spread, assuming the underlying treasury security’s yield is constant

Default rates



Test Your Skills Now!
Take a Quiz now
Reviewer Name