Private corporations are in constant need of funds. They could be expanding to a new geography or launching a new product. Companies raise capital either through debt or equity instruments. Corporate bonds are debt instruments with a specific tenure and interest rate. The lenders, or the bondholders, receive periodic coupon payments at this rate. The company repays the principal amount or face value to the bondholders at the maturity date.
Corporate bonds have a higher risk than government bonds as their repayment depends on the company’s profitability. Therefore, they pay a higher return than government bonds to compensate for the risk. You can invest in different types of corporate bonds available for investors in India. Let’s learn about them in detail.
What are Corporate Bonds?
Corporate bonds are debt instruments issued by companies to borrow capital for various projects or to manage their day-to-day expenses. When you buy a bond, you lend money to the company in exchange for a return on the loaned amount. There are various categories of corporate bonds in India and they’re classified based on a number of factors such as security, equity characteristics and interest payments among others.
Also Read: Bonus Shares: Meaning, Types, Advantages & Limitations
Types of Corporate Bonds Based on Security
Based on the security cover available, corporate bonds can be classified into:
1. Senior Secured Bonds
These corporate bonds are backed by specifically designated collateral. Therefore, in the event of default by the company, the collateral can be used to pay off the bondholders. This classification also denotes priority in the event of liquidation of the company. Secured bondholders get priority in payment of dues before other bondholders in case the company files for bankruptcy.
2. Senior Unsecured Bonds
While these bondholders are high on the priority list of payments in case of default, they are prioritised just after all secure bondholders. That is, there is no specific collateral backing them, and they are paid off by utilising the general assets of the company.
3. Junior and Subordinated Bonds
These bonds are not secured by any form of collateral. The holders of these bonds are paid after all senior bondholders are paid. Due to the high risk inherent in these bonds, they offer higher rates of interest to investors. The only credibility behind these bonds is the credit worthiness of the issuer. Therefore, it is advisable to check the credit rating of these bonds before investing in them.
4. Guaranteed and Insured Bonds
These bonds are not guaranteed by the issuer but by an independent third party. While there is no collateral backing them, the credit worthiness of two parties instead of one makes them relatively more secure than other unsecured bonds. However, even here, it’s only the creditworthiness of the third party that investors can bank on while investing in these bonds.
Types of Corporate Bonds Based on Equity Characteristics
Some bonds have characteristics of equity embedded in them. Based on these characteristics, they are classified into:
1. Convertible Bonds
Convertible bonds are debt instruments that can be converted into equity shares of the issuer company upon the occurrence of specific trigger events at a specified time. The conversion ratio is pre-decided by the issuer and informed to the investor.
Therefore, the market price of convertible bonds takes the expected stock price at conversion into account. Also, due to this choice of conversion, these bonds offer investors slightly lower interest rates.
Convertible bonds can be:
- Fully convertible if all the bonds can be converted into stocks as per a specific conversion rate.
- Partly convertible if only a certain percentage of bonds can be converted to shares of the company.
2. Non-Convertible Bonds
As the name suggests, these are pure debt instruments with no option to convert them into equity shares.
Types of Corporate Bonds Based on Interest Payment
Based on the type of interest, corporate bonds can be classified into:
1. Fixed-Rate Bonds
These bonds pay a fixed coupon rate to investors at regular intervals. Thus, the returns to the investor are fixed, guaranteeing a steady income stream.
2. Floating-Rate Bonds
These bonds pay an interest rate linked to an external market benchmark. The rate is reset periodically and updated as per the changes in the benchmark rate.
3. Zero-Coupon Bonds
These bonds do not offer any coupon payments to the investor. The bonds are sold at a discount to their face value. The only return you get from these bonds is the difference between the discounted issue price and the face value at redemption.
Types of Corporate Bonds Based on Maturity
Based on the maturity period, bonds can be classified into:
Short-Term Bonds: These bonds have a maturity of less than one year.
Medium-Term Bonds: These bonds have a maturity of between 1 and 5 years.
Long-Term Bonds: These bonds have a maturity period greater than 5 years.
Relation Between Bond Security and Recovery Rates
The recovery rate refers to the total value of a bond’s interest and payments that are likely to be recovered in the event of a default. For instance, if you have invested Rs. 1,00,000 in a bond with a recovery rate of 30%, it means that if the bond defaults, the payout to you will be Rs. 30,000.
Naturally, the recovery rate increases with the increase in the security of the bond. This is because if a secured bond issuer defaults, designated collateral will be used to pay off the bondholders.
As the priority of payment decreases, so do the recovery rates as the generic assets of the company will start depleting after paying off the senior debt holders. That is, senior secured bonds will have higher recovery rates than senior unsecured bonds, which in turn will have higher recovery rates than junior debt.
You have seen the types of corporate bonds available for investors in India. Before investing in any of them, you must understand the security-based categories of corporate bonds and select the ones that match your risk profile. Also, if you want to diversify your portfolio, you may also consider bonds with equity characteristics.
Furthermore, based on your investment horizon and financial goals, you can choose to invest in different categories of corporate bonds as per maturity and interest payments.
There is also an option to invest in corporate bond funds. These funds manage the risk-return profile as per their mandate in return for a fee. These funds spare you the hassle of tracking minor changes in bond prices, interest rates, etc. However, it is important to carefully understand the investment strategy of the bond fund to ensure that your financial goals and the fund’s mandate align.
FAQs about Types of Corporate Bonds
Are corporate bonds safe?
Corporate bonds are a safer investment choice than investing in the same company’s equity. However, they are often prone to default risk, primarily when issued by companies with lower vintage. It is safer to invest in high-rated corporate bonds backed by collateral.
How much interest do corporate bonds provide?
Corporate bonds usually provide higher interest rates than government bonds. Typically, you can expect returns ranging from 7% to 12 % per annum from corporate bonds.
What happens upon the maturity of a corporate bond?
At the maturity of a corporate bond, the principal borrowed is repaid at face value. If you had chosen cumulative interest payment, you would also receive the same. In the case of periodic interest payments, since the interest amount has already been paid, you only get the principal invested at maturity.
Which is a better option, a corporate bond or a government bond?
It depends on your risk appetite and financial goals. Government bonds are better if you are looking for a highly safe investment option. However, corporate bonds are better if you seek higher returns at relatively higher risk.
Krishna is an investment professional with a demonstrated history of working in Debt Capital Markets. He has completed his B.E. (Hons) in Computer Science Engineering from BITS Pilani and MBA (Finance) from JBIMS, Mumbai. He is currently working as Investments Principal at Wint Wealth. Previously he worked at Kotak Mahindra Bank at their DCM desk and Northern Arc Capital at their Structured Finance desk.