 Personal Finance PowerPoint Presentation, Corporate Bond. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia Corporate Bond, which you can find online. Take a look at the references, resources, continue your research from there. This by James Chen, updated November 29, 2020. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping them in mind. We're now asking, what is a corporate bond? A corporate bond is a type of debt security that is issued by a firm and sold to investors. So when we think about bonds and investing in bonds, generally oftentimes the first thought would be going to the government or U.S. government bonds. Those are often used as like a baseline comparison to be comparing other bonds to because it's not likely that the U.S. government is going to default on the bonds given the fact that they have taxation power and can basically print money. The concept of a bond in general, you can think of as similar to like a loan, it's going to be a fixed income type of investment usually because the interest payments are going to be preset typically in a bond. So the issuer of the bond basically wants money. So we're going to loan the money in essence to the issuer of the bond if it were the government, then the government, if it was a corporation, to the corporation in exchange for in essence a promise, the bond, to repay that principal, usually repaying the principal at the maturity or the end time frame that has been pre-established oftentimes for the bond and also give us basically kind of like the rent for the use of that money in a similar way as if we were to rent say an apartment building to someone. We expect the principal or apartment building, the thing we rented back at the end and possibly periodic payments such as rent payments for the use of it. Those periodic payments with regards to loaning money would then be in the form of interest payments. So keeping that in mind that company gets the capital it needs and in return the investor is paid a pre-established number of interest payments at either fixed or variable interest rates. So oftentimes when we think about bonds, when we think of like corporate bonds we're usually thinking kind of a fixed rate, the semi-annual kind of payments or a typical way that we think about them or a typical design or structure for the bonds where we can easily kind of calculate the ending amount that we're going to get paid at the end or the maturity of the bond and then we can compare these stream of payments that we might get rather than monthly like in a rental situation possibly semi-monthly in that situation to kind of figure out the value and comparing different types of bonds noting again you have to take into risk when you do that and the government bonds are usually lower risk than company bonds but large company bonds typically still have a fairly low amount of risk and possibly a little bit more of a return. So when the bond expires or reaches maturity at the expiration of the bond the payment cease and the original investment is returned. So the backing for the bond is generally the ability for the company to repay which depends on its prospects for future revenues and profitability. So clearly you want to say okay is this company a going concern meaning are they going to be able to continue business in the future, continue generating revenue that revenue that they're going to need in the future to pay back the bond because presumably they need the money in order to grow and if they grow then of course they'll have the revenue to pay back the bond. So in some cases the company's physical assets may be used as collateral so you might have some kinds of companies that have more physical assets that might be used as collateral if necessary if they don't have the cash flow, the cash streams to pay back understanding corporate bonds and the investment hierarchy high quality corporate bonds are considered a relatively safe and conservative investment. Investors building balance portfolios often add bonds in order to offset riskier investments such as growth stocks. So when we think about our portfolio we often think about having our equity investments and then we can have our mix of equity investments versus the bonds that we might have and we might have a mix of bonds some of those bond mix might be government bonds which are highly safe in terms of you don't think the government is going to not be able to pay back the bonds but the returns are quite low typically if you have quality corporate bonds usually higher bigger company corporate bonds those still seem pretty safe although they can't tax and they can't basically print money just so they're not as safe as the government bonds but still fairly safe smaller company bonds are going to be less safe. So overall over a lifetime these investors tend to add more bonds and fewer risky investments in order to safeguard their accumulated capital. Retirees often invest a large portion of their assets in bonds in order to establish a reliable income supplement. So as we get older the typical strategy would be to switch or shift from equities to bonds because the equities become more risky as your time horizon goes down less time to be able to invest over there for the fluctuations in the market have a more significant impact when you're investing in bonds more of your investment are in bonds then you might have more flexibility looking at bonds that might have a higher return than say basically government bonds you might have a mix then of different kinds of bonds including corporate bonds. So in general corporate bonds are considered to have a higher risk than US government bonds as a result interest rates are almost always higher on corporate bonds even for companies with top flight credit quality. So notice obviously if the government has you can think about as zero almost default risk because they can print money then large corporations are not likely to go bankrupt because they're solid established corporations but they're not nearly zero risk of default like the like the government bonds you would think with more risk however often comes the market's going to want a greater return. So if I'm an investor if I'm the market and I can invest in government bonds with more risk or corporate bonds the only way the corporate bonds are going to be able to sell their bonds is if they give a higher return. So you're typically going to be taking the higher return on the corporate bonds in exchange for the fact that you have some more default risk than with the government bonds. So the difference between the yields on highly rated corporate bonds and US treasuries is called the credit spread corporate bond ratings before being issued to investors bonds are reviewed for the credit worthiness of the issuer by one or more of three United States ratings agencies. You got the standard and pours global rating Moody's investor services and Fitch rating. So these tools are great note that they are not perfect however because we have seen times when there's high rating towards things that haven't done as well right. So there's nothing's perfect no rating system is perfect but having a rating system hopefully one that we can depend on is a great tool of course. So each has its own ranking system but the highest rated bonds are commonly referred to as triple A rated bonds. So triple A you would think the risk would be quite low on those given the rating system the lowest rated corporate bonds are called high yield bonds due to their greater interest rate applied to compensate for their higher risk. These are also known as junk bonds. So junk bonds is kind of like a disparaging sounding term but note that if you're a smaller company then if someone's going to be investing if you want to get money through loaning by issuing bonds basically then you're going to have to give a higher rate of return because there's no way that to your default rate you're more likely to go bankrupt than large established companies and of course the government. So therefore you would think that with those bonds you'd have a higher return possibility with them. So bond ratings are vital to alerting investors to the quality and stability of the bond in question. These ratings consequently greatly influence interest rates, investment, appetite and bond pricing. How corporate bonds are sold? Corporate bonds are issued in blocks of 1,000 generally in face or par value so you could typically think about bonds oftentimes being purchased in chunks of 1,000 dollar amounts almost all have a standard coupon payment structure so the payments that you're going to be paying are typically a standard kind of payment for the interest so you could think of streams of future flow of cash would typically be due to the interest payments and then the maturity amount received at end or maturity of the bond. So typically a corporate issuer will enlist the help of an investment bank to underwrite and market the bond offering to investors. The investors receives regular interest payments from the issuer until the bond matures. At that point the investor reclaims the face value of the bond. The bonds may have a fixed interest rate or a rate that floats according to the movements of a particular economic indicator. So corporate bonds sometimes have all provisions to allow for early prepayment if prevailing interest rates change so dramatically that the company deems it can do better by issuing a new bond. Investors may also opt to sell bonds before they mature so note that if you buy the bond directly from the corporation you're in essence buying basically on the primary market for example and then you could sell the bond on the secondary market so the secondary market would typically mean that the issuer of the bond in this case corporation not involved it's two traders that are now buying and selling on the secondary market so if a bond is sold the owner gets less than the face value the amount is worth it's determined primarily by the number of payments that still are due before the bond matures. Investors may also gain access to corporate bonds by investing in any number of bond focused mutual funds or ETFs. So oftentimes as an investor or individual investor we may not be buying and selling individual bonds but having bonds as part of our overall portfolio that we might be putting into like under the umbrella say of an IRA or a 401k plan and using the mutual fund or ETF capabilities in order to get that exposure a little bit more easily for individual investors. Why corporations sell bonds so why are they doing this why are they selling bonds because they want money right they want loans because in the growth spurt of a company as they're growing you would expect that hopefully they're taking more capital in the ability and for expansion in order to generate future revenue. So corporate bonds are a form of debt financing they are a major source of capital for many businesses along with equity bank loans and lines of credits they often are issued to provide the ready cash for a particular project the economy wants to undertake so if the economy is if the company the company wants to take if the company is expanding they might want to obviously get the cash flow in order to make whatever expansion that they want to do debt financing is sometimes preferable to issuing stocks equity financing because it typically cheaper for the borrowing firm and does not entail giving up ownership stake or control in the company. So on the company side of things you're saying okay we want to grow we want to get bigger how is that going to happen how can we get financing to invest in a new plant or something like that we could issue more stocks but the stocks have voting rights in the company so that means you're dealing with equity kind of investments if you if you do if you go that route or you can basically issue the bonds which means you've got to pay back the bonds and deal with the interest component on the bonds those are some ways you can generate what we call capital which is basically money that they might use to invest into the company to buy things like assets and plants in order to increase hopefully grow and make future generation of revenue. So generally speaking a company needs to have constant earnings potential to be able to offer debt securities to the public at a favorable coupon rate if a company's perceived credit quality is higher it can issue more debt at lower rates. So it's just like obviously on the market if we're on the market we're going to be buying the debt security we're buying bonds if I could buy government bonds and I get the same rate as corporate bonds then I'm going to buy government bonds because they're more secure because the government can't really default if they can tax and they can print money. So that means corporate bonds in general are going to have to give a higher rate of the return if they want anybody to invest in them and obviously the bigger and the more secure the corporation is the more faith you have that they'll be able to pay the less risk that there is involved and therefore you're going to put your money there all else equal as compared to a smaller company that has more risk the smaller company therefore is going to have to have a higher rate in order for people to invest in it that's how the markets going to basically work. When a corporation needs a very short term capital boost it may sell commercial paper which is similar to a bond but typically matures in 270 days or less the difference between corporate bonds and stocks and investor who buys a corporate bond is lending money to the company and investor who buys stock is buying an ownership share of the company. So the bond you're dealing with companies here so you're buying two kinds of investments possibly for the same company if I buy shares in the company then I'm buying kind of an ownership component of the company if I have that those shares individually I have actually the ability to kind of vote for things like the board of directors and so on and I'm hoping that the company goes up in value which may provide me with dividends if they choose to give back dividends or it may provide me an increase in the value of the stock if they reinvest the earnings increase in the stock value that I could then sell if I'm investing in bonds with them then I have more of a fixed investment generally and I'm hoping I'm not really betting that they increase in the company goes up in terms of their valuation so much because that might not affect my bonds too much although it might make them a little bit more secure I'm just hoping that they're secure enough to be paying back what I locked in in terms of my fixed income payments on the bonds the interest in the payment at maturity. So the value of stock rises and falls and the stock rises or falls with it. The investor may make money by selling the stock when it reaches a higher price or by collecting dividends paid by the company or both by investing in bonds and investor is paid interest rather than profits. The original investment can only be at risk if the company collapses. So notice again on the bond you get paid first typically even if it does basically collapse and so you're hoping that they don't fall apart because you just want the revenue screen stream if they go up in value you're not getting any added value in terms of interest payments whereas if you had the stock then of course as the stock price goes up you would benefit from that as the stock price goes down you would not. So one important difference is that even a bankrupt company must pay the bondholders and other creditors first so unless the government comes out of this stuff the bondholders should get paid first that's the point of being a bondholder. Stock owners may be reimbursed for their losses only after all those debts are paid in full. Companies may also issue convertible bonds which are able to be turned into shares of the company if certain conditions are met.