Corporate Bonds

 

Product Overview

Features and Benefits

Risks

Types of Corporate Bonds

 

 

 

Product Overview

Corporate bonds are fully taxable debt obligations issued by corporations. These bonds fund capital improvements, expansions, debt refinancing or acquisitions that require more capital than would ordinarily be available from a single lender.

 

Investors in corporate bonds lend money to the issuing corporation in exchange for interest payments and repayment of the principal at a set maturity date.

 

Corporate bond rates are set according to prevailing interest rates at the time of the issue, the credit rating of the issuer, the length of the maturity and other terms of the bond, such as a call feature.

 

There are a number of key variables to consider when investing in corporate bonds including, but not limited to, credit quality of the issuer, coupon rate, price, yield maturity and redemption features.

 

 

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Features and Benefits

Ratings

When considering an investment in corporate bonds, it is important to remember that risk and potential return are linked. Higher potential returns are typically associated with higher levels of risk.

 

Yields

Corporate bonds have historically been one of the highest yielding of all taxable debt securities.

 

Interest or coupon can be paid monthly, quarterly or semi-annually and is fully taxable. Most corporate securities pay interest semi-annually. The coupon may be fixed, variable or floating, or payable at maturity. Regular way settlement on corporate securities is three business days

 

The yield advantage that Corporate can provide over Treasuries may be enough to outpace inflation over the long run. However, because the interest earned on corporate bonds is fully taxable, fixed income buyers should carefully evaluate their tax situations before investing.

 

There is also an increased risk of default which is not a factor with Treasuries.

 

Higher degree of choice

The number of sectors and issuers within sectors in the corporate bond market generally allows investors to tailor a bond portfolio to their needs. Investors do need to consider that each issuer has its own unique risk profile.

 

Secondary Market

A secondary market exists for many corporate bonds sold prior to maturity. The of the market and features of each bond affects its liquidity or ability to be bought and sold on the secondary market. As with all fixed income securities, however, the market price of a bond might be significantly higher or lower than its face value due to fluctuations in interest rates and other price determining factors.

Investors can review recent trade activity through TRACE information provided in the Securities Details of each offering. This will assist in the evaluation of liquidity risk.

Investors need to remember that some issues can be thinly traded and, therefore, illiquid. A high issuance rate of new issue corporate securities is a common reason for thin trading on the secondary market.

 

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Risks

 

While it may seem appealing to look at bonds that offer higher yields, investors should consider those higher yields to be a sign of potentially greater risk.

Diversification is also a key consideration when investing in corporate bonds. Investors need to consider the risk associated with being too heavily weighted in a single company's bonds or a single sector (i.e. industrial, automotive).

 

Since corporations are subject to competition and changing economic patterns, the risk characteristics of any bond may change substantially. From the date of issuance to the investor's purchase and sale, some level of price volatility can be expected in most bonds.

 

 

 Credit Risk

 

Corporate bonds are subject to credit risk; however these risks can be reduced by investing in higher rated securities and/or by building a diversified portfolio. Bonds with lower credit ratings are more likely to be in danger of default. If a bond issuer fails to make either a coupon or principal payment on its bonds as they come due, or fails to meet some other provision of the bond indenture, it is said to be in default.

Market risk

 

Price volatility of corporate bonds increases with the length of the maturity and decreases as the of the coupon decreases. Changes in credit rating can also affect prices. If one of the major rating corporations lowers its credit rating of a particular issue, the price of that security usually declines.

Event risk

 

A corporate bond's payments are dependent on the company's ability to finance its debt. Unforeseen events could impact the issuer's ability to meet their financial commitments.

 

Call or Prepayment risk

Many corporate bonds are callable and have a predetermined call schedule. Callable bonds can be redeemed or paid off at the issuer's discretion prior to the bonds' maturity date. Typically an issuing corporation will call its bonds when interest rates fall, leaving the investor with less favorable reinvestment possibilities. Investors may suffer capital loss and lower yields as a result of their bond being called by the issuer. When evaluating corporate bonds, an investor should know whether call options exist and when they may be exercised. The offerings table on Fidelity.com displays an attribute of CP for those offerings which are call protected i.e. cannot be called. The Securities Detail for those bonds not call protected shows a link to a complete call schedule.

 

Make-whole calls

Some new issues have an option for the issuer to call the bond as interest rates decline. Issuers may call these bonds at par plus a premium. This feature is referred to as a make-whole call. The amount of the premium is derived from the yield of a comparable Treasury security plus additional basis points. Because the cost to the issuer can often be significant, make whole calls are not frequently invoked.

Sector risk

 

Bonds issued by corporations in each of the five main sectors of the economy can be affected differently by the above risks.

 

Industrials - Includes manufacturers, mining companies, energy companies, retailers and service-related industries. This sector can be influenced by corporate events, consumer demand, and changes in the economic cycle.

 

Banks/finance - Includes money center banks, regional banks, savings and loans, brokerage and insurance companies and finance companies. This sector can be influenced by changes in loan demand and interest rate volatility, as well as debt commitments in foreign countries where economic downturns can impact profits.

 

Public utilities - Includes telephone companies, electric utilities, gas pipelines, gas transmission companies and water companies. Bonds in this sector can be influenced by changes in governmental regulations and call provisions.

 

Transportation - Includes airlines, railroads, and trucking companies. This sector can be influenced by changes in oil prices, travel patterns, and safety records.

Yankee and Canadian bonds - The Yankee and Canadian bond sector includes dollar-denominated bonds issued in the U. S. by foreign countries or governments, usually by the foreign branches of American corporations. This sector can be influenced by changes in the political atmosphere and availability and liquidity of the issues may be limited, especially in volatile markets.

 

Inflation Risk

The risk that the rate of the yield to call or maturity of the investment may not provide a positive return over the rate of inflation for the period of the investment.

 

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Types of Corporate Bonds

 

Convertible

Convertible corporate bonds can be exchanged for a specified amount of a different security, often the common stock of the issuing company. Convertible bonds can combine the fixed income characteristic of bonds with the potential appreciation characteristic of equities. There are often provisions attached to convertible bonds, which place restrictions on when a bond can be converted. Additionally, because convertible bonds can typically be exchanged for the equity of the issuer, these bonds may be susceptible to fluctuations in price inherent with the stock market.

The investor in a zero coupon corporate bond buys the bond at a discount from face value (par), holds the bond until maturity and makes a profit based on the difference between the buy price and the face value of the bond.

 

 Zero coupon

A portion of interest income from zero coupon corporate bonds is taxable annually even though no annual payments are made. The full value, including accrued interest, is paid at maturity.

Market prices of zero coupon bonds tend to be more volatile than bonds which pay interest regularly.

 

Floating rate

The coupon on a floating rate corporate bond changes periodically based on some pre-determined benchmark, such as the spread above the yield on a six-month Treasury security. Some floating-rate bonds use non-financial benchmarks, such as the price of a commodity to determine the rate. Also, some floating-rate bonds called inverse floaters have coupons that move in the opposite direction of their respective benchmarks.

 

Floating rate bonds use a short-term interest rate benchmark and can reset more than once a year.

 

Variable/adjustable rate

Variable and adjustable rate corporate bonds are similar to floating rate bonds but they use a long-term interest rate benchmark and only typically reset once a year.

 

Callable/Putable

The issuer of a callable corporate bond maintains the right to redeem the security on a set date before maturity. This may be disadvantageous to an investor if reinvestment is only available at a lower rate.

 

With a putable security, the investor has the right to put the security back to the issuer, which can be advantageous to the investor if prevailing interest rates are rising.

 

Step up

The investor in a step up corporate bond receives a fixed rate of interest until the call date, at which time the coupon increases if the bond is not called.

 

Step down

Interest on step down securities is paid at a fixed rate until the call date, at which time the coupon decreases if the bond is not called.

 

 

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