Corporate Bonds

Taking loan directly from public can help the corporate to reduce its interest cost and help public to get good returns. Another reason why company prefers debts is Tax Shield.

Corporate Bonds Introduction

As the name suggests, corporate bonds are debt (debentures) instruments issued by big corporate bodies to fund their long term projects. Taking loan directly from public can help the corporate to reduce its interest cost and help public to get good returns. Another reason why company prefers debts is Tax Shield.

Let’s understand this with an example,

Suppose two companies have 10 Lakh EBIT (Earnings before Interest and Tax). Company A and B both have 40 Lakh invested but company A’s capital structure has 20 Lakh Equity and 20 Lakh Debt and company B’s capital structure has only equity of 40 lakh.

corporate bonds example

From the above table we can see that even though both the companies have same earnings, because company A has issued debt worth 20 lakh their ROE is very high when compared to Company B. Understand this very carefully, you and you brother have 40L rupees combined. You start your business and earn 7 lakh profits after taxes. This is company A’s scenario.

Now look at this way, you start your business and your brother gives you loan of 20 lakh so you have 40 lakh and on that you earn 5 lakh 60 thousand profit. This amount is less than the first scenario but if you see carefully in total you and your brother have earned a total of 7 lakh 60 thousand (5 Lakh 60 thousand your income and 2 lakh your brothers interest income) so now scenario two is better and this was possible because of the debt present in capital structure and tax benefits given to that.

Key Terms

  • Issues Price

    Price at which bonds are issued is issue price. It is generally same as face value but in zero coupon bonds they are issued at discount of face value.

  • Face Value

    It is also called par value or principal value. Interest is calculated on face value so if interest rate is 10% and face value is 100 interests will be 10 rupee. Face value is the amount which the company will pay to bondholder at the time of maturity. Sometimes companies pay extra compared to face value and it is called premium.

  • Interest/Coupon

    It is the Interest inflow which we get at regular interval or at predefined dates. It also tells us the interest rate we are getting on the bond.

  • Interest Frequency

    How frequent the company pays the bond holder monthly quarterly, semi-annually or yearly.

  • Maturity Date

    The date at which the company will pay back our principal amount

  • Call/Put Options

    It is the Date at which company/holder can apply their right and redeem their bond.

  • Redemption / Maturity Value

    It is the amount which we receive at the end of the maturity. If we receive greater than our face value we call it redeem at premium, less than our face value we call it redeem at discount and if we get same amount as per our face value we call it redeem at par.

  • Dirty Price

    It means Price of bond including the accrued interest. Trading on exchanges takes place on this price and it changes every day.

  • Clean Price

    The price of bond excluding the accrued interest.Trading on exchanges takes place on this price and it changes every day.

  • Clean Price

    The price of bond excluding the accrued interest

Price of Bond and Yield

Yield means how much are we getting from the bond in total. Price and yield are inversely related, rise in price will lead to fall in yield and vice-versa.

Yield Vs Coupon Rate

Face value and market price of security might not be the same and because of this, difference between Yield and coupon rate arises. Coupon payments are calculated on face value of bonds. Coupon rate is different from Yield.
Relationship between Price, Coupon Rate and Yield is mentioned below:

yield versus coupon rate

Types of Yield

  • Current Yield

    It is Simple return which investor gets on purchase of bonds. Example we purchase 10% 200 rupees bond of ATS Ltd. at 180. Current yield would be (10% of 200/180)*100 which is 11.11%.

  • Yield to Maturity

    If we hold the bond till maturity the percentage of interest we will get is called Yield to Maturity or YTM. YTM also includes the principal component in it. Calculating YTM is bit tricky but don’t worry we will understand this in great detail in the last chapter of this module.

  • Nominal Yield

    Nominal Yield is nothing but percentage of coupon or interest to be paid on bonds at regular interval of times. To calculate this we have to divide the annual coupon rate with the par value of stock. Nominal yield may or may not measure the return correctly because face value and current market price may not be the same.

  • Yield to Maturity of Zero Coupon Bond

    Zero coupon bonds do not give any periodic payment instead they give a big lump sum amount at the end. To calculate we need to know Time value of Money which I will explain in last chapter of this module so till then hold your excitement

  • Realized Yield

    It is calculated when investor wants to hold a bond only for a limited period and not till maturity. In such a scenario he will sell the bond in future and we have to project the future price for calculation. Predicting this price is hard so we can just get an estimation of the realized yield.

Types of Bonds

types of bonds Maturity
  • Short: Less than 1 Year
  • Medium: 1 to 5 Years
  • Long: More than 5 Years
  • Perpetual: No Maturity. Issued by some banks
  • Zero Coupon: No interest rate
  • Fixed Coupon: Fixed Interest rate
  • Floating Coupon: Interest rate changes as per market
  • Call: Gives right but not the obligation to the issuer to redeem the bond
  • Put: Gives the right but not the obligation to the bondholder to sell their bond
  • Single : Principal is paid at the time of redemption
  • Multiple: Principal and Interest are paid during the life of the bond.
  • Convertible: Can be converted to equity upon maturity
  • Non-Convertible: Cannot be converted to equity

Things to look before investing in corporate bonds

  • Ex-Date and Record Date

    Record date is date till which if we have bought the bond, we are eligible for interest for that period. If we have purchased the bond after record date, then we are not eligible for the interest for that period. Record date is date by companies and is based on the record date. Exchanges set the Ex-date of interest payment. If we have invested in stock after ex-date, we are not eligible for interest for that period and the price at which we have purchased is ex interest price.

  • Credit Rating

    Ratings are very important because it tells us about the credibility of the bond, how good the company who has issued the bond is. Higher the Tax rating better the company and more will be liquidity because more people would prefer a higher rating bond.

  • Tax

    All gains from corporates bonds are taxable.

  • Interest Rate

    If interest rate rises then price of bond will fall.

  • Liquidity

    Currently bond market is not very liquid compared to stock market so individual should plan his cash outflow, budget and expenses accordingly because many times he may not be able to sell his bond in open market.

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