What are corporate bonds?

Corporate bonds are one of the cornerstones of global financial markets. They are instruments issued by private companies, such as banks or industrial companies, to finance and expand their operations.

When you invest in corporate bonds, you become a creditor of the issuing company. Upon maturity, you are entitled to receive the capital initially invested, plus interest as remuneration. However, the strength of these bonds is closely linked to the company’s ability to maintain profitability over time.

These bonds offer attractive return opportunities, but they also present significant risks. credit risk, interest rate risk, currency risk and liquidity risk are just some of the challenges investors face.

In this article, we will explore in detail how corporate bonds work, analyzing the different risks associated with them and offering practical advice on how to manage them to maximize your earning potential.

The definition of corporate bonds

Corporate bonds, also known as corporate bonds, company bonds or private bonds, are financial instruments issued by private companies, such as banks or industrial companies, to raise capital needed to expand or diversify their activities.

When an investor buys a corporate bond, he becomes a creditor of the issuing company and, at the maturity of the bond, has the right to receive the initially invested capital, plus interest as compensation for his employment. The ability of a company to repay these bonds depends on its ability to generate revenue and maintain profitability.

Corporate bonds are considered riskier than government bonds, which is why they offer higher interest rates to compensate for this risk. However, they are less risky than stocks, as companies must repay their debts, including bonds, before distributing profits to shareholders. In developed financial markets, corporate bonds are a major source of liquidity for companies, often preferred to bank loans to avoid shareholder dilution.

How Corporate Bonds Work and How They Are Classified

Corporate bonds are a debt instrument through which companies raise capital. When an investor buys a corporate bond, he or she lends money to the issuing company and, in return, receives periodic interest and the repayment of the principal at maturity. These securities can be classified according to various criteria, each of which carries different characteristics and levels of risk.

Classification by cash flow structure
Corporate bonds can be classified by their cash flow structure:

• Zero Coupon: these bonds do not pay periodic interest but are issued at a lower price than the nominal value and repaid at full value at maturity;
• Fixed rate: they offer a constant interest rate for the entire duration of the bond;
• Variable rate: the interest rate can vary based on specific parameters, such as the performance of a benchmark index.

Classification by type
Corporate bonds are also distinguished by their type:

• Plain Vanilla: these are traditional bonds with standard conditions;
• Structured: the repayment or remuneration is linked to the performance of other financial assets, such as convertible bonds;
• Subordinate: These bonds are repaid only after all other senior debts of the company have been satisfied.

Classification by rating
The rating of bonds indicates the credit risk associated with them:

• Investment grade: considered less risky, they offer lower interest rates;
• High Yield: also known as junk bonds, they are riskier and therefore offer higher interest rates;
• Unrated: bonds that are not rated by rating agencies, which makes them more difficult to evaluate in terms of risk.

Classification by type of issuer
Bonds can be issued by different types of companies:

• Financial: issued by banks and credit institutions;
• Industrial: issued by companies operating in various production sectors.

Corporate Bonds: What Are the Risks?

Investing in corporate bonds involves several types of risks that investors must carefully consider. The main risks include credit risk, interest rate risk, currency risk, and liquidity risk. Each of these can significantly affect the return and safety of your investment.

Credit Risk

Credit risk is the possibility that the bond issuer will not be able to meet its payment obligations. Corporate bonds are rated for the creditworthiness of the issuer by independent rating agencies such as Standard & Poor’s, Moody’s, and Fitch. These agencies issue summary ratings in the form of letters and/or numbers, indicating the ability of the issuer to repay the debt. Bonds with a high rating are classified as “Investment Grade” and are considered less risky, while those with a lower rating are called “High Yield” or “junk bonds” and are riskier.

Ratings significantly influence the market and investors’ decisions, as they provide an indication of the stability and reliability of the issuer. The agencies can also change their ratings: an improvement in the rating is known as upgrading, while a deterioration is called downgrading. Companies with a high rating are more likely to raise capital at lower costs than those with worse ratings. However, investing in bonds with a lower rating may be worthwhile for some investors, depending on their risk profile and financial knowledge.

credit risk can also vary based on economic conditions: during phases of economic expansion, the risk is generally limited, while in phases of recession it tends to increase. Another measure of credit risk is represented by credit spread, which is the difference between the interest rate of a low-risk security (for example, a corporate investment grade) and a riskier one (for example, a “corporate high yield”) with similar characteristics in terms of maturity and liquidity. In periods of economic slowdown, credit spreads tend to widen, increasing the required return differential between more and less risky securities, while they narrow in periods of economic growth.

To mitigate credit risk, it is advisable to diversify the portfolio. More experienced investors can use instruments such as credit derivatives, including credit default swaps, to protect themselves from this risk.

Interest Rate Risk

Bonds are sensitive to changes in interest rates, especially fixed-rate bonds. The correlation between rates and yield is inverse: an increase in interest rates causes the value of bonds to decrease, since new securities issued will offer higher rates. This has two effects: the reinvestment effect, positive, which allows liquidity to be reinvested at higher rates, and the price effect, negative, which sees the value of existing securities decrease.

A good measure of the interest rate risk of a bond is the duration, which represents the weighted average maturity of the expected cash flows for the security. A high duration implies a greater sensitivity of the price of the security to changes in interest rates, while a low duration indicates a lower price volatility. To protect themselves from interest rate risk, investors can use derivatives such as interest rate futures, options and swaps.

Currency Risk

Currency risk refers to the possibility that the currency in which the bond is denominated may fall in value against the investor’s reference currency. This risk is particularly relevant for investors who buy bonds issued in currencies other than their own.

Liquidity Risk

Liquidity risk is the possibility that a bond may not be sold quickly at a fair price. This risk increases with the duration of the security and in periods of economic uncertainty, when markets are less stable. Bonds with low liquidity may be difficult to sell and require significant discounts to find a buyer.

Original article published on Money.it Italy.
Original title: Corporate bond, cosa sono le obbligazioni societarie