Corporate Bonds

What are Corporate Bonds?

A corporate bond is a bond issued by major corporations and can be divided into five major groups: industrials, transportations, utilities, banks and other finance companies, and finally international. Bonds issued from the industrial sector would include manufacturing, mining, and retail oriented companies. Transportation bonds would then be issued by airlines, trucking companies, and even railroads. Utilities would include companies which would fall into the following groups; water, electric, and telephone. International bonds would be issued by foreign entities such as foreign countries, municipalities, and agencies.

Event Risk

Corporate bonds are like no other in that they have an implied event risk. Takeovers, corporate restructuring, and even LBO's can have dramatic consequences to a bonds credit rating and even price. Unless you were acting on inside information, it was nearly impossible to predict these dramatic shifts in a company and therefore; corporate bond issuers were forced to provide additional bond features to remove some of the uncertainty associated with corporate bonds.

Event Risk Mitigation (Special Features)

Poison pill provisions, floating rate notes, and putable bonds are a few key features that were added to corporate bonds to ease the investors' mind.

Poison Pill Provision

The poison pill provision is probably the most important risk prevention measure that a corporation can make; it allows shareholders to buy the stock of the acquiring company or more of the same stock at a heavily discounted price, usually half of the market rate, during a takeover situation. The provision attempts to thwart would be takeover attempts by forcing the acquirer to negotiate terms with the board of directors on the terms of the takeover. If the board is amenable to the terms, they will recant the pill. If not, the pill could be triggered; and shareholders can exercise the option to purchase shares at a deep discount. This would have negative ramifications to the acquirer as it would dilute their interest in the company.

Floating Rate Notes

Floating rate notes (FRN) are corporate bonds that have a variable coupon structure to protect purchasers against interest rate risk. The coupon is reset usually every three months using a benchmark index as a basis; usually a short term treasury instrument or LIBOR. Sometimes, floaters will have a floor in place to provide that much more protection to the corporate bond holder against interest rate movements. The idea behind a floating rate note is to protect the bond holder against rate fluctuations and at the same time keeping the bond value close to par.

Putable Bonds

A corporate bonds with a putable feature allows the bond holder to return, or "tender", the bond back to the issuer at par before the bond's maturity date. This feature is designed to protect a bonds value against interest rate fluctuations. The intervals in which this put feature can be executed are specified in the bond indenture. Effectively, a corporate bond with a putable option turns the security into a shorter term instrument.

Putable bonds are not as great in interest rate environments that are shifting sharply; this is so due to the fact that the bond holder will need to wait for specific intervals in which they may tender the bond back to the issuer. Additionally, similar to its callable bond counterpart, the putable bond carries an option premium which will reduce your yield.

Credit Risk

Analyzing credit risk for corporate bonds is a little more complex than a more simple method in which municipal bonds are be evaluated. Corporate bonds have a tiered repayment structure, similar in concept to the one that a CMO has. Each bond issuer may have multiple issuances; each of these issues will receive different ratings from the credit agencies due to the fact that they have different repayment structures and conditions. For example, there may be a senior class of debt, and then a subordinated class of debt which is less senior. Obviously, the senior class will bear a higher credit rating.

Junk Bonds

The term "junk bonds" refers to high-yield corporate bond issuances which are classified as non-investment grade. They are speculative in nature and have very low credit ratings. Standard and Poors defines junk bonds as issues with a rating lower than BBB while Moody's classifies a bond as junk below Baa3. Typically, issuers of junk bonds have just gotten into deep financial issues and need to raise cash immediately; other times, issuers may be trying to re-emerge from bankruptcy. In either case, the corporate bonds credit quality is low and investors who purchase them are speculating on the future of the company. Junk bonds are typically purchased at tremendous discounts to par; many times you can get them for 10 to 20 cents on the dollar.

While junk bonds may seem to be a risky proposition; nearly 1 out of every 5 companies are rated in "junk" status. The market for these bonds has become more diversified; including some bigger names and more recently, public growth companies looking for financing. Junk bonds actually provide a portfolio with diversification since these companies typically are on their own page and doing their own thing regardless of what the general market is doing. Additionally, junk bond yields are quite a bit higher than their treasury equivalents. If you can spot the right investment, the compounding interest can be quite staggering over the life of the bond.

In a nutshell, if you plan on investing in junk bonds, you can expect a riskier investment with great returns if it works out. Be prepared to lose your money if the company does not work out as you thought; therefore, never throw a large portion of your portfolio into these investments.

Conclusion

The corporate bond market can offer very high yields but they come with a price; extra risk. We spoke about a few ways to mitigate that risk but also run your numbers and remember that treasury equivalents in term may have lower yields but offer different tax structures. Therefore, run your taxable equivalent yield formula and solve for tax exempt yield to see if the corporate bond provides you with the added risk premium when compared to a riskless treasury bond. When buying a corporate bond, be sure to ask the key questions: What is the credit rating? Is there a putable option? Is there a callable option embedded into the bond? How liquid is the bond? Is the corporate bond listed on an exchange (these will tend to have more liquidity)?

Tim Ord
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