Corporate Bonds

How a corporate bond works

A corporate bond is a debt security through which a company borrows from investors. The issuer agrees to pay interest under stated terms and repay principal at maturity, subject to its ability to perform and the bond documents. The investor is a creditor, not an owner of the company, unless the bond has a conversion feature that is exercised.

The bond's prospectus and indenture describe key terms: face amount, coupon, payment schedule, maturity, seniority, collateral, covenants, call rights, and events of default. The issuer may have a trustee that acts for bondholders. The specific documents control; two bonds from the same company can have different rights and risk.

A company may issue bonds to finance operations, capital projects, acquisitions, or debt refinancing. Bonds can be secured by specified collateral or unsecured general obligations of the company. Unsecured does not mean there are no assets in a bankruptcy; it means that the particular bond lacks a specific pledged collateral claim under its terms.

Bondholders generally have priority over shareholders in claims against the issuer, but recovery depends on available assets, legal ranking, collateral value, and other creditor claims. A bond is not automatically safe because it is debt. The issuer can default, and a bond's market price can decline before maturity.

Coupon, price, and yield

The coupon rate is the stated annual interest rate applied to face value. A $1,000 face-value bond with a 5% annual coupon pays $50 a year, often in two $25 installments. The coupon does not change simply because the bond trades at a different market price, unless the instrument has a variable-rate feature.

Yield to maturity considers the purchase price, coupon payments, maturity value, and time to maturity under assumptions about holding the bond and reinvesting payments. If the market yield rises above the coupon, the bond generally trades below par so a new buyer's total expected return reflects the lower price. If market yield falls below coupon, the price may rise above par.

Suppose a $1,000 bond has a 4% coupon and comparable market yields rise to 6%. Its annual coupon remains $40, but investors can obtain higher yields on new issues. The existing bond's price must generally fall below $1,000 to offer a competitive yield, all else equal. The exact price depends on remaining time, cash-flow schedule, credit spread, and optionality.

Current yield is annual coupon divided by market price. If the $1,000-face bond with a $40 coupon trades at $800, current yield is $40 ÷ $800 = 5%. This calculation ignores any gain or loss between purchase price and maturity value and the timing of cash flows. It is not yield to maturity.

A premium bond bought above par may repay only face amount at maturity, creating a principal decline relative to purchase price. A discount bond may repay more than its purchase price if the issuer pays at maturity, but it also may have greater credit risk or other features. Compare total expected cash flows, not just coupon income.

Credit risk and repayment capacity

Credit risk is the possibility that the issuer does not make interest or principal payments as promised. An issuer's capacity depends on cash generation, liquidity, business conditions, debt burden, and access to financing. A company can remain profitable but have insufficient cash at a particular due date, or it can have assets but face refinancing difficulties.

Review financial statements and debt disclosures. Consider operating cash flow, interest expense, debt maturities, secured claims, pension obligations, leases, and guarantees. Examine whether cash is available to the bond issuer or held in a subsidiary with restrictions. A consolidated balance sheet may not show which entity owes the bond.

Credit ratings are opinions about relative credit risk at a point in time, not guarantees or investment recommendations. Ratings can change as the issuer's condition and assumptions change. A rating scale differs among agencies. Review rating methodology and the issuer's own disclosures rather than relying solely on a letter grade.

Default recovery depends on the bond's seniority, collateral, covenants, and the issuer's resources. Secured creditors may have a claim on pledged assets, but collateral may lose value or be subject to prior liens. Senior unsecured debt ranks ahead of subordinated debt under relevant agreements, but priority does not ensure full payment.

A corporate bond may be guaranteed by a parent or affiliate. A guarantee is only as strong as its terms and guarantor's ability to perform. Identify who owes the payment, whether the guarantee is unconditional or limited, and where the guarantor ranks relative to other creditors.

Interest-rate and spread risk

Fixed-rate bond prices generally move inversely to market yields. If rates rise, the present value of fixed payments falls; if rates fall, the fixed payments become more attractive. Longer-maturity bonds are often more sensitive to rate changes than shorter bonds, though coupon and embedded options affect price behavior.

Corporate bond yields include a spread over a reference yield, often a comparable-maturity Treasury. The spread can reflect compensation for default risk, liquidity, tax, and other factors. It is not a pure measure of default probability. If investors demand a wider spread, the bond's market price can fall even when Treasury yields do not change.

A credit spread can widen when issuer fundamentals weaken or when market risk appetite falls. It can also move with liquidity and technical supply and demand. Compare instruments of similar maturity and quote basis. A spread difference between two bonds does not by itself prove one issuer will default.

If a client plans to hold to maturity, interim price changes may matter less if the issuer pays and the client does not need to sell. But holding does not remove default, inflation, opportunity cost, or reinvestment risk. A forced sale before maturity can crystallize a loss.

Secured, unsecured, senior, and subordinated

A secured bond is backed by specified collateral, such as real property, equipment, or other assets. The lien and collateral terms determine what is pledged and the claim's priority. A secured label does not promise that collateral will cover the principal after costs and prior claims.

An unsecured bond relies on the issuer's general credit rather than a specific asset pledge. Senior unsecured bonds rank ahead of subordinated obligations as defined by the documents and applicable law. Subordinated debt agrees to a lower priority relative to specified claims, often in exchange for a higher yield.

A bondholder should check whether the issuer can incur additional debt, pledge assets elsewhere, pay dividends, or sell major assets under the covenants. Covenant protections vary. Some covenants restrict actions, while others require the issuer to maintain a condition or provide reports. A covenant breach may trigger remedies or acceleration under contract terms.

Capital structure changes over time. New secured debt can prime existing unsecured bondholders in some structures. A merger, asset sale, or refinancing may affect the location of assets and the issuer's obligations. Read change-of-control, ranking, and asset-sale provisions where relevant.

Call and other embedded features

A callable bond gives the issuer the right to redeem before maturity under specified terms. Issuers may call bonds when refinancing is favorable, often after rates decline. The investor then receives the call price and must reinvest, potentially at a lower yield. Call schedules and call premiums matter.

A call feature can limit price appreciation when yields fall because the issuer may redeem the high-coupon bond. A callable bond may therefore offer a higher yield than a comparable noncallable bond to compensate investors. Compare yield to call and yield to worst where applicable, using the security's actual call schedule.

Convertible bonds give the holder a right to exchange debt for a specified amount of issuer stock under stated terms. Conversion may provide equity upside but the bond still has credit and price risk. The conversion ratio, price, adjustment provisions, and seniority should be reviewed.

Variable-rate or floating-rate bonds adjust interest payments according to a reference rate and contract formula. They may have less price sensitivity to changes in the reference rate than fixed-rate bonds, but can carry credit, reset, cap, floor, and basis risk. A coupon that resets does not assure the issuer can pay.

Worked case: comparing two issuers

Two hypothetical companies issue five-year bonds with $1,000 face value. Bond A pays a 5% coupon and is senior unsecured. Bond B pays 7% and is subordinated. Both trade near par, but B's higher coupon may compensate for lower priority, weaker credit, or other terms. The coupon alone does not show which bond offers better value.

The investor reviews cash flows and finds Company A has stable operating income, modest maturities, and a strong cash reserve. Company B has more debt, a large maturity next year, and depends on rolling over short-term financing. The 2-point coupon difference may not compensate for B's refinancing and subordination risks, depending on price and the investor's objectives.

If the market spread on Company B widens by 2 percentage points, the bond price can decline even if its coupon remains 7%. An investor selling early may lose principal. If the issuer later defaults, subordinated status can reduce recovery relative to senior claims. These outcomes are possible risks, not certain predictions.

A careful comparison also checks call provisions, covenants, collateral, guarantees, and fees. If Bond A is callable next year and Bond B is not, the yield and reinvestment comparison changes. Use the prospectus and indenture rather than a summary table alone.

Worked case: a callable bond

A hypothetical company issued a 7% callable bond at par. Market yields later fall to 4%. The issuer may call the bond at a specified price after the call date and refinance at lower cost. The investor may receive principal earlier than planned and lose the opportunity to keep earning 7% for the full maturity.

If the investor paid a premium, a call at par may also produce a principal loss. The investor should compare yield to maturity with yield to the earliest call date and understand the call price. A quoted yield to maturity can overstate the return if the security is likely to be called earlier.

If rates rise instead, the issuer is less likely to call a high-coupon bond, but its market price may fall. The investor may be left holding a below-market security for longer. Call risk is asymmetric and should be considered together with interest-rate sensitivity.

Liquidity and trading

Corporate bonds trade in markets that vary by issuer, issue size, credit quality, and market conditions. Some issues trade frequently; others can be difficult to sell quickly. A dealer quote may include a markup or reflect a limited market. Investors should understand bid-ask costs and possible price concessions.

A bond's stated face amount is not its current market value. If the investor needs cash, sale proceeds depend on prevailing rates, credit spreads, remaining term, accrued interest, and liquidity. A high yield may reflect difficulty trading as well as issuer risk.

Public information may be less extensive for some issuers than for others. Review financial statements, rating reports, offering documents, and ongoing disclosures. A broker's inventory or recommendation does not replace independent review of the issuer and security.

A practical corporate bond review

Identify issuer and obligor, face amount, coupon, maturity, payment schedule, price, and yield measure. Check seniority, security, collateral, guarantees, covenants, call features, and events of default. Determine whether the quoted yield assumes holding to maturity or a possible call.

Assess ability to pay using cash flows, liquidity, debt burden, maturities, and business risks. Examine credit ratings as one input and consider how a weaker economy or tighter funding could affect repayment. Review collateral value and legal priority if the bond is secured.

Consider rate and liquidity exposure. Estimate how a yield or spread change might affect price, and ask whether the client may need to sell early. Compare with alternatives of similar maturity and risk rather than choosing the highest coupon.

For suitability, connect the bond's credit quality, maturity, income, call risk, and liquidity to the client's goals, time horizon, tax status, and portfolio concentration. A bond can serve a purpose, but a fixed payment schedule does not make it free of loss.

How to answer Series 65 questions

Recognize a corporate bond as a company debt obligation. The issuer promises payments under its documents, but credit risk remains. A bond's coupon is based on face value; yield depends on price, timing, and cash flows.

When market yields rise, existing fixed-rate bond prices generally fall. Secured debt has specified collateral, senior debt ranks ahead of subordinated claims under the documents, and callable debt can be redeemed early by the issuer. Read the specific terms.

Do not treat a rating or senior label as a guarantee. Assess issuer capacity, maturity, covenants, liquidity, and client needs. For a calculation, use the exact price, coupon, maturity, call schedule, and yield convention in the question.

Sources

SEC Investor.gov, What Are Corporate Bonds? and Bonds or Fixed Income Products; Federal Reserve, Treasury Yields and Corporate Bond Yield Spreads; NASAA Series 65 Test Specifications, Section I. Examples are hypothetical.