Corporate bonds are debt securities issued by private and public corporations. Companies issue corporate bonds to raise money for a variety of purposes, such as building a new plant, purchasing equipment, or growing the business. When one buys a corporate bond, one lends money to the “issuer,” the company that issued the bond. In exchange, the company promises to return the money, also known as “principal,” on a specified maturity date. Until that date, the company usually pays you a stated rate of interest, generally semiannually. While a corporate bond gives an IOU from the company, it does not have an ownership interest in the issuing company, unlike when one purchases the company’s equity stock.

Need for Corporate Bonds

One of the announcements in the Budget 2005-06 was to appoint a high level expert committee on corporate bonds and securitization to look into the legal, regulatory, tax and market design issues in the development of corporate bond market.

A committee was formed under the Chairmanship of Dr. R.H. Patil to look into the factors inhibiting the development of an active debt market and recommend policy actions necessary to develop an appropriate market infrastructure for the growth of an active corporate bond market.

A few of the recommendations for the development of an active secondary market for corporate bonds are :-

• Establish a system to capture all information related to trading in corporate bonds as accurately and as close to execution as possible and disseminate it to the market in real time.

• Clearing and settlement of transactions in this market must adhere to the IOSCO standards.

• Based on increase of awareness amongst the participants to introduce online order matching system

Yield

Yield is a critical concept in bond investing, because it is the tool used to measure the return of one bond against another. It enables one to make informed decisions about which bond to buy. In essence, yield is the rate of return on bond investment. However, it is not fixed, like a bond’s stated interest rate. It changes to reflect the price movements in a bond caused by fluctuating interest rates. The following example illustrates how yield works.

• You buy a bond, hold it for a year while interest rates are rising and then sell it.

• You receive a lower price for the bond than you paid for it because, no one would otherwise accept your bond’s now lower-than-market interest rate.

• Although the buyer will receive the same amount of interest as you did and will also have the same amount of principal returned at maturity, the buyer’s yield, or rate of return, will be higher than yours, because the buyer paid less for the bond.

• Yield is commonly measured in two ways, current yield and yield to maturity.

Current yield

• The current yield is the annual return on the amount paid for a bond, regardless of its maturity. If you buy a bond at par, the current yield equals its stated interest rate. Thus, the current yield on a par-value bond paying 6% is 6%.
• However, if the market price of the bond is more or less than par, the current yield will be different. For example, if you buy a Rs. 1,000 bond with a 6% stated interest rate at Rs. 900, your current yield would be 6.67% (Rs. 1,000 x .06/Rs.900).

Yield to maturity

It tells the total return you will receive if you hold a bond until maturity. It also enables you to compare bonds with different maturities and coupons. Yield to maturity includes all your interest plus any capital gain you will realize (if you purchase the bond below par) or minus any capital loss you will suffer (if you purchase the bond above par).

Valuation of Corporate Bonds

Corporate bonds tend to rise in value when interest rates fall, and they fall in value when interest rates rise. Usually, the longer the maturity, the greater is the degree of price volatility. By holding a bond until maturity, one may be less concerned about these price fluctuations (which are known as interest-rate risk, or market risk), because one will receive the par, or face, value of the bond at maturity.

The inverse relationship between bonds and interest rates—that is, the fact that bonds are worth less when interest rates rise and vice versa can be explained as follows :-

• When interest rates rise, new issues come to market with higher yields than older securities, making those older ones worth less. Hence, their prices go down.

• When interest rates decline, new bond issues come to market with lower yields than older securities, making those older, higher-yielding ones worth more. Hence, their prices go up.

• As a result, if one sells a bond before maturity, it may be worth more or less than it was paid for.

 

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