How do corporate bonds work?

Corporate bonds are debt securities issued by companies to raise capital for various business needs, such as expanding operations, funding new projects, or refinancing existing debt. When you invest in a corporate bond, you're lending money to a company in exchange for periodic interest payments and the return of the principal amount at maturity. But how exactly do corporate bonds work? Let’s dive into the details in this blog.

1. What Are Corporate Bonds?

A **corporate bond** is essentially a loan that investors give to a company. When you buy a corporate bond, you are lending money to that company, which agrees to pay you interest (known as the **coupon**) on the bond periodically, usually every six months. The company also promises to return the principal amount (the original investment) when the bond matures, which can range from a few years to several decades.

In simpler terms, buying a corporate bond means you're becoming a creditor to the company. You’re essentially providing the company with funding in exchange for regular interest payments and the promise of getting your money back once the bond matures.

2. How Do Corporate Bonds Work?

When a company issues corporate bonds, it is essentially borrowing money from the bondholder (the investor). The company promises to pay periodic interest on the bond, which is typically fixed, for the life of the bond. At the end of the bond's term, the company repays the principal amount to the bondholder.

• Issuance: The company issues bonds to raise capital. These bonds are sold to investors on the bond market.
• Coupon Payments: Investors receive interest payments on the bonds, usually every 6 months, for the duration of the bond’s term.
• Principal Repayment: At the end of the bond’s term (maturity), the company repays the principal to the investor, completing the loan repayment.

Example: Suppose you buy a ₹1,00,000 corporate bond with an interest rate (coupon) of 7% and a maturity of 10 years. You will receive 7% of ₹1,00,000 (₹7,000) as interest every year, paid semi-annually. At the end of 10 years, the company will repay your ₹1,00,000 principal.

3. Types of Corporate Bonds

Corporate bonds come in different forms depending on the features that define their terms. Here are some common types:

• Fixed-Rate Bonds: These bonds have a fixed interest rate throughout the life of the bond. This means you will receive the same amount of interest periodically until maturity.
• Floating-Rate Bonds: The interest rate on these bonds fluctuates based on an underlying benchmark, such as LIBOR or the RBI’s repo rate. This makes the coupon payments variable.
• Convertible Bonds: These bonds can be converted into the company’s stock at a later date, usually at the bondholder's discretion. Investors may choose this option if they believe the company's stock price will rise.
• Zero-Coupon Bonds: These bonds do not pay periodic interest. Instead, they are sold at a discount to their face value and the bondholder receives the full face value at maturity.

4. Risks Involved in Corporate Bonds

While corporate bonds are generally considered safer than stocks, they are not without risks. Here are some of the key risks involved in investing in corporate bonds:

• Credit Risk: If the company experiences financial trouble or goes bankrupt, it may fail to make interest payments or repay the principal amount. This is known as **credit risk**.
• Interest Rate Risk: If interest rates rise, the value of your corporate bond may fall, as newly issued bonds will offer higher yields, making your bond less attractive.
• Liquidity Risk: Corporate bonds can be harder to sell quickly in the secondary market compared to more liquid investments like stocks or government bonds.

To mitigate these risks, investors can research the company's financial health, industry trends, and credit ratings before investing in corporate bonds. Bonds from well-established companies with strong credit ratings generally have lower risk.

5. How to Invest in Corporate Bonds?

To invest in corporate bonds, you can purchase them through a broker, a financial institution, or online trading platforms. In India, you can buy corporate bonds through banks, brokers, or the Bombay Stock Exchange (BSE). Corporate bonds can be purchased either in the primary market (directly from the issuing company) or the secondary market (where bonds are traded among investors).

Here’s how you can invest in corporate bonds:

• Step 1: Open a Demat and trading account with a broker or through an online investment platform.
• Step 2: Research corporate bonds and choose those that align with your investment goals and risk tolerance.
• Step 3: Place an order through your broker or investment platform, either for new issues or for bonds available on the secondary market.
• Step 4: Monitor the performance of your corporate bonds and decide if you want to hold, sell, or buy additional bonds.

6. Conclusion

Corporate bonds are an attractive investment option for those seeking stable income through periodic interest payments. While they come with risks like credit risk, interest rate risk, and liquidity risk, they can be a solid choice for investors looking to diversify their portfolios beyond stocks. Always research the financial health of the issuing company and choose bonds that match your investment goals.