The capital market mainly comprises the equity market and the debt market. The market brings together those who have capital and those who seek capital. Debt securities are typically less risky as compared to equities. In case of liquidation, bondholders are paid before shareholders. Bonds are the most preferred debt investments with a fixed interest rate. There can be a variety of government bonds and corporate bonds.
What are Corporate Bonds?
Companies borrow money in the bond market. Corporate bonds can be issued by private as well as public corporations. The raised funds can be used by businesses for expansion, fund new business ventures, or meet their various expenditures. These funds are open to retail investors. If you buy a corporate bond, you are lending money to the corporation. Primarily banks, pension funds, mutual funds, and insurance companies invest in corporate funds. These are attractive to investors because of higher potential yields as compared with bank FDs. However, risk and returns are parallel to each other, and the underlying bond ranges from low to higher risk. Bonds vary in liquidity and carry major risks, including credit risk and call risk.
There are two broad categories of corporate bonds: investment grade and speculative-grade (or high-yield) bonds. Speculative-grade bonds are of lower credit quality with higher default risk. Newer firms and firms in volatile sectors or struggling finances generally issue these bonds with a higher interest rate (coupon). There is a higher default probability on these bonds. In contrast, investment-grade bonds are highly rated bonds depending on the financial health of issuers and are considered safer than speculative ones.
The Changing Value of Bonds
The changing value of bonds affects its trading. When an investor buys bonds, the bond issuer will pay periodic interest payouts until its maturity, and the bonds can be redeemed at face value at maturity. However, bonds can be traded in the secondary markets too.
The face value of bonds remains the same at maturity but the bond’s yield changes constantly depending on various factors like the central bank interest rate regime, company’s liquidity status, etc. The investment value goes up or down with the changes in the interest prices. The bond can be sold at a discount or a premium with the change in market interest rates.
Bond Trading on Public Exchanges
Investors can trade most bonds in the over-the-counter (OTC) markets. Generally, the deals in the bond market take place between dealers/brokers and investors. However, some bonds are traded on public exchanges also. Bonds have some distinct features, and trading bonds on public exchanges comes with the following pros and cons:
Pros
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Order-driven trade matching platform
An order-driven market increases the transparency of trades as the entire order book is available for investors who want to access such information. An order-driven market keeps prices transparent when buyers/sellers are ready to buy or sell securities.
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Easy access of bonds to retail investors
There are many investors who are unfamiliar with the concept of bond investing. Exchanges allow retail investors to participate easily in the bond market.
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Reduced credit risk
Trading corporate bonds at public exchange means trading under a regulatory framework. It decreases the instances of defaults by bond issuers
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Reliable clearing and settlement
All trades in corporate bonds on the public exchanges are reported for settlement through NSE Clearing. Both buyer and seller want to settle the corporate bond trade, and then the settlements are carried out through the DP accounts.
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Efficient price discovery
Price discovery refers to the process of setting the spot price for a security. Public exchange helps efficient price discovery where a buyer and a seller agree on the same set price, and a transaction occurs at agreed terms.
Cons
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Challenging Bond Trading on Public Exchanges
Bonds are traded differently than stocks due to diversity/liquidity, and it is diversity itself that makes bond trading challenging on public exchanges.
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Trading Issues due to diversity
Bonds are diverse by nature. They vary by their characteristics, maturities, and yields. Due to diversity, there are numerous issuers that issue bonds with different characteristics, which makes it difficult to trade bonds on public exchanges.
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Current price listing issues
Since changing interest rates and credit ratings affects the price of a bond, it is difficult to list bonds on current prices. Trade time between bond issues that can last weeks or even months also makes it hard to list the prices.
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Liquidity
Corporate bonds have longer maturities. Bonds are traded infrequently, resulting in disrupted supply between buyers and sellers. Most traders do not trade bonds sufficiently to get sustained income.
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Substantially large average size of a bond trade
Since most debt instruments carry the minimum amount required to invest, which is pretty high, it is hard to find buyers at the time of urgent financial need.
Benefits of Investing in Corporate Bonds
- Source of Regular and Stable Income
Companies issue bonds with a promise to pay the fixed interest regularly and repay the invested amount. Therefore, bonds are a regular source of income for bondholders. In contrast, companies are not bound to pay a dividend to their stockholders.
- Higher Returns
Corporate bonds/funds have the potential to generate higher returns as compared to government securities. The fundamental reason for investors to invest in corporate bonds is higher yields compared with PSU/Government bonds.
- Multiple options to invest in Bonds
You can consider various types of corporate bonds to meet your different financial goals. Bonds can be issued for differing values, payment terms, convertibility, etc. It can be short-term bonds with a maturity period of less than five years, medium-term bonds with a maturity period of 5-10 years, or long-term bonds for 10+ years. Corporate bonds also have different coupon structures, like zero-coupon rate bonds and fixed coupon rate bonds.
- Priority for the principal repayment with respects to the equity and preference shareholders
Corporate bonds are debt instruments, giving bondholders the status of a creditor. Bondholders are ahead of other creditors to get repayments during a bankruptcy proceeding. They have a better chance to recover their initial investment during the company liquidation.
- Tax Efficiency
Generally, corporate bonds are utilized as long term investments. When you invest in listed corporate bonds for more than one year, you need to pay taxes @10.4%. Otherwise, it will be according to the investors’ tax bracket. Therefore it is a beneficial investment for taxpayers who fall in higher tax brackets.
- Convertible Bonds
Sometimes the company offers to voluntary surrender the bonds in lieu of principal repayment at face value or discount or convert the bonds into equity shares
- Lower Volatility
The bond market is not as volatile as shares. You can enjoy your fixed returns without being worried about market volatility.
- Diversified Portfolio
Bonds are preferred to give stability to a portfolio. It is a preferred diversification option for most investors. Corporate bonds offer an opportunity to choose from different sectors, and structures to meet your investment objectives.
- Safety with credit-quality characteristics
Corporate bonds are assigned a rating based on historical performance and ability to repay commitments. The higher the assigned bond rating, the safer it is. You can expect timely repayment of principal and payment of interest.
Thus, you can consider high rated corporate bonds for regular returns and capital protection as investment bonds are a less risky investment option.
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