Corporate Bonds

A corporate bond is a loan to a company. Companies issue bonds to fund operations, expansion, acquisitions and refinancing. Because companies can default, corporate bonds pay higher yields than government bonds of similar maturity, and that extra yield, the credit spread, compensates investors for credit risk and lower liquidity. The corporate bond market is huge, with trillions of dollars outstanding in the US alone, and it is a major source of funding for businesses of every size.

Key features#

Investment grade vs high yield#

The boundary between BBB and BB is important because many institutions can only hold investment grade bonds. A downgrade below that line, a "fallen angel", can force selling. See Credit Ratings and Investment Grade vs High-Yield Bonds.

Yield and spread#

corporate yield = government yield of similar maturity + credit spread

Seniority and recovery#

If a company defaults, bondholders are paid in order of seniority:

1. Secured debt (backed by specific assets).
2. Senior unsecured bonds.
3. Subordinated bonds.
4. Preferred and common equity last.

Historical studies by Moody's and S&P show average recovery rates of roughly 40% for senior unsecured bonds, with wide variation and lower recoveries for subordinated debt. See Default Probability and Recovery Rate and Bankruptcy and Restructuring.

Covenants#

Covenants limit what issuers can do, such as taking on more debt, paying large dividends or selling key assets. Investment grade bonds usually have few covenants; high yield bonds tend to have more. In recent years, weaker "covenant lite" structures have become common, especially in leveraged loans.

Callable bonds#

Many corporate bonds are callable: the issuer can repay early, usually after a set date, often at a premium to par. Issuers call bonds when rates fall, so investors face reinvestment risk. Yield to call and yield to worst account for this. See Yield to Maturity.

How corporate bonds trade#

Corporate bonds trade over the counter. In the US, trades are reported to FINRA's TRACE system, providing price transparency. Many bonds trade infrequently, so liquidity can be poor, especially in stress. Bond ETFs have become a popular way to gain diversified exposure and trade throughout the day. See Bond Trading.

Risks#

• Credit risk: default or downgrade.
• Interest rate risk: prices fall when government yields rise.
• Spread risk: spreads widen in recessions and crises.
• Liquidity risk: hard to sell some bonds quickly at fair prices.
• Event risk: leveraged buyouts or acquisitions can sharply raise a company's debt.

In March 2020, corporate bond spreads widened sharply and liquidity dried up until the Federal Reserve announced corporate bond purchase facilities, an unprecedented step.

Frequently asked questions#

What is a corporate bond?#

A debt security issued by a company that pays interest and repays principal at maturity.

Why do corporate bonds pay more than Treasuries?#

Because companies can default and their bonds are less liquid, investors demand a credit spread above government yields.

What is a fallen angel?#

A bond that was investment grade but has been downgraded to high yield, often forcing some investors to sell.

Next, learn about tax advantaged local government debt in Municipal Bonds.