Corporate bonds are a type of financing used by firms when they wish to initiate expansion or growth. Unlike corporate stock, they do not equate to company ownership and are used exclusively for corporate financing. And unlike government bonds, corporate bonds may have a "call" and "put" option, which can affect the price of the bond over its life cycle.
Defining Corporate Bonds
Like government bonds, corporate bonds are a type of debt financing. Unlike government bonds, corporate bonds are issued by the private sector. When bonds are purchased by investors, they are in effect making a loan to the company, which will in turn use the funds for new investments, such as company expansion or acquisitions. All bonds have a principal, usually of $1,000 or $5,000, which is the amount of money loaned to the company. The bond will also have a maturity date, which is when the company repays the amount borrowed to the investor. Until the maturity date, the bond may or may not offer additional benefits such as coupon payments and call options.
Many corporate bonds, like government bonds, offer their investors a semiannual periodic coupon payment. This gives an investor the incentive to buy bonds, as it potentially creates a profit. The coupon payment is based on a percentage of the principal, called a current yield. As a rule of thumb, keeping all other factors constant, the higher the current yield, the higher the bond's risk of defaulting.
Call and Put Options
Unlike government bonds, corporate bonds may have a "call" option. A call option allows the bond issuer to pay out the entire outstanding principal before the bond's maturity date. This has an advantage for the issuing firm, as it allows the company to re-issue new bonds but at a lower interest rate, thereby saving the firm money on coupon payments. A corporate bond that has a call option usually has a higher yield, as it gives investors an incentive to invest in bonds that may not last their full life cycle. Furthermore, callable bonds may have a "put" option, which allows an investor to redeem the bond before maturity. Bonds with put options tend to have a lower yield than those without.
The Corporate Bond Lifecycle
Although the par value of a corporate bond usually remains the same, the bond's price will change over its lifetime. When bonds are first issued, their price is usually below the par value. This is because there is a greater length of time until the principal is repaid, and there is a greater degree of risk of default or the bond being called. As the maturity date approaches, the bond's price tends to increase. Finally, when a bond is one coupon payment away from maturity, its price is close to the last coupon payment plus its par value. This is because there is a much greater chance of the bond maturing. The price of a bond will also increase when interest rates fall, and will fall in value when interest rates rise.