Lesson 2: Introduction to U.S. Corporate Bonds

What Are Corporate Bonds?

Corporate bonds are debt securities issued by corporations to raise capital for various purposes. When you buy a corporate bond, you’re lending money to the company in exchange for regular interest payments and the return of principal at maturity.

Why Companies Issue Bonds

1. Capital for Growth

• Funding expansion projects
• Research and development
• Market entry or acquisition financing

2. Working Capital

• Day-to-day operations
• Inventory management
• Accounts receivable financing

3. Debt Refinancing

• Replace higher-cost debt
• Extend maturities
• Improve financial flexibility

4. Balance Sheet Management

• Maintain optimal debt-to-equity ratio
• Tax advantages (interest is tax-deductible)

Corporate Bond Characteristics

Secured vs. Unsecured Bonds:

• Secured Bonds: Backed by specific collateral (equipment, property)
• Unsecured Bonds (Debentures): Backed only by issuer’s creditworthiness

Seniority in Capital Structure:

• Senior Secured: First claim on assets
• Senior Unsecured: Next in line after secured creditors
• Subordinated: Lower priority, higher risk, higher yield
• Convertible: Can be converted to company stock

Credit Ratings and Risk Assessment

Major Rating Agencies:

• Moody’s: Aaa (best) to C (worst)
• Standard & Poor’s: AAA (best) to D (worst)
• Fitch: AAA to D

Investment Grade vs. High Yield:

• Investment Grade: BBB-/Baa3 and above
• Lower default risk
• Lower yields
• Suitable for conservative investors
• High Yield (Junk Bonds): Below BBB-/Baa3
• Higher default risk
• Higher yields
• More volatile prices

Corporate Bond Yields

Types of Yields:

1. Current Yield

• Annual interest payment ÷ Current bond price
• Simple measure of income return

2. Yield to Maturity (YTM)

• Most comprehensive measure
• Total return if held to maturity
• Includes coupon payments and capital gain/loss

3. Yield to Call

• For callable bonds
• Return if called before maturity

Yield Spreads:

• Difference between corporate bond yield and comparable Treasury yield
• Measures compensation for credit risk
• Widens during economic stress, narrows during stability

Callable and Puttable Bonds

Callable Bonds:

• Issuer can redeem before maturity
• Usually callable after specified period
• Investors receive call premium
• Risk for investors when rates fall

Puttable Bonds:

• Investor can sell back to issuer before maturity
• Protection against rising rates
• Lower yield than non-puttable bonds

How to Invest in Corporate Bonds

1. Individual Bonds

• Direct purchase through broker
• Control over maturity, credit quality
• Higher minimums ($5,000-$10,000 typical)

2. Bond Funds

• Mutual funds or ETFs
• Professional management
• Instant diversification
• Lower minimums
• Continuous price fluctuation

3. Bond Ladders

• Portfolio of bonds with staggered maturities
• Regular income and principal returns
• Reinvestment flexibility
• Interest rate risk management

Risks of Corporate Bond Investing

1. Credit Risk (Default Risk)

• Issuer fails to make payments
• Mitigated by diversification and credit analysis

2. Interest Rate Risk

• Bond prices fall when rates rise
• Longer maturities = higher sensitivity

3. Liquidity Risk

• Difficulty selling at fair price
• More pronounced for smaller issues

4. Call Risk

• Bonds called away when rates fall
• Reinvestment at lower rates

5. Inflation Risk

• Purchasing power erosion
• Fixed payments lose value

Analyzing Corporate Bonds

Financial Ratio Analysis:

• Interest Coverage Ratio: EBIT ÷ Interest Expense (higher = better)
• Debt-to-Equity Ratio: Total Debt ÷ Shareholders’ Equity
• Current Ratio: Current Assets ÷ Current Liabilities

Industry Considerations:

• Cyclical vs. defensive industries
• Regulatory environment
• Competitive position

Macroeconomic Factors:

• Economic cycle position
• Industry outlook
• Interest rate environment

Practical Exercise

Analyze two corporate bonds:

1. An investment-grade bond (A rated)
2. A high-yield bond (BB rated)

Compare:

• Yield difference (spread over Treasuries)
• Typical maturity
• Average coupon rates
• Recent price volatility

Why might an investor choose one over the other?