Download Corporate Bond www.AssignmentPoint.com A corporate bond is a

Corporate Bond
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A corporate bond is a bond issued by a corporation in order to raise financing
for a variety of reasons such as to ongoing operations, M&A, or to expand
business. The term is usually applied to longer-term debt instruments, with
maturity of at least one year. Corporate debt instruments with maturity shorter
than one year are referred to as commercial paper.
Definition
The term "corporate bond" is not strictly defined. Sometimes, the term is used to
include all bonds except those issued by governments in their own currencies.
In this case governments issuing in other currencies (such as the country of
Mexico issuing in US dollars) will be included. The term sometimes also
encompasses bonds issued by supranational organizations (such as European
Bank for Reconstruction and Development). Strictly speaking, however, it only
applies to those issued by corporations. The bonds of local authorities
(municipal bonds) are not included.
Trading
Corporate bonds trade in decentralized, dealer-based, over-the-counter markets.
In over-the-counter trading dealers act as intermediaries between buyers and
sellers. Corporate bonds are sometimes listed on exchanges (these are called
"listed" bonds) and ECNs. However, vast majority of trading volume happens
over-the-counter.
Market
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By far the largest market for corporate bonds is in corporate bonds denominated
in US Dollars. US Dollar corporate bond market is the oldest, largest, and most
developed. As the term corporate bond is not well defined, the size of the
market varies according to who is doing the counting, but it is in the $5 to $6
trillion range.
The second largest market is in Euro denominated corporate bonds. Other
markets tend to be small by comparison and are usually not well developed,
with low trading volumes. Many corporations from other countries issue in
either US Dollars or Euros. Foreign corporates issuing bonds in the US Dollar
market are called Yankees and their bonds are Yankee bonds.
High Grade vs High Yield
Corporate bonds are divided into two main categories High Grade (also called
Investment Grade) and High Yield (also called Non-Investment Grade,
Speculative Grade, or Junk Bonds) according to their credit rating. Bonds rated
AAA, AA, A, and BBB are High Grade, while bonds rated BB and below are
High Yield. This is a significant distinction as High Grade and High Yield
bonds are traded by different trading desks and held by different investors. For
example many pension funds and insurance companies are prohibited from
holding more than a token amount of High Yield bonds (by internal rules or
government regulation). The distinction between High Grade and High Yield is
also common to most corporate bond markets.
Bond types
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The coupon (i.e. interest payment) is usually taxable for the investor. It is tax
deductible for the corporation paying it. For US Dollar corporates, the coupon is
almost always semi annual, while Euro denominated corporates pay coupon
quarterly.
The coupon can be zero. In this case the bond, a zero-coupon bond, is sold at a
discount (i.e. a $100 face value bond sold initially for $80). The investor
benefits by paying $80, but collecting $100 at maturity. The $20 gain (ignoring
time value of money) is in lieu of the regular coupon. However, this is rare for
corporate bonds.
Some corporate bonds have an embedded call option that allows the issuer to
redeem the debt before its maturity date. These are called callable bonds. A less
common feature is an embedded put option that allows investors to put the bond
back to the issuer before its maturity date. These are called putable bonds. Both
of these features are common to the High Yield market. High Grade bonds
rarely have embedded options. A straight bond that is neither callable nor
putable is called a bullet bond.
Other bonds, known as convertible bonds, allow investors to convert the bond
into equity. They can also be secured or unsecured, senior or subordinated, and
issued out of different parts of the company's capital structure.
Valuation
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High Grade corporate bonds usually trade on credit spread. Credit spread is the
difference in yield between the bond and an underlying US Treasury bond (for
US Dollar corporates) of similar maturity. Credit spread is the extra yield an
investor earns over a risk free instrument (US Treasury) as a compensation for
the extra risk.
Derivatives
The most common derivative on corporate bonds are called credit default swaps
(CDS) which are contracts between two parties that provide a synthetic
exposure with similar risks to owning the bond. The bond that the CDS is based
on is called the Reference Entity and the difference between the credit spread of
the bond and the spread of the CDS is called the Bond-CDS basis.
Risk analysis
Compared to government bonds, corporate bonds generally have a higher risk of
default. This risk depends on the particular corporation issuing the bond, the
current market conditions and governments to which the bond issuer is being
compared and the rating of the company. Corporate bond holders are
compensated for this risk by receiving a higher yield than government bonds.
The difference in yield (called credit spread) reflects the higher probability of
default, the expected loss in the event of default, and may also reflect liquidity
and risk premia.
Other risks in corporate bonds
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Default Risk has been discussed above but there are also other risks for which
corporate bondholders expect to be compensated by credit spread. This is, for
example why the Option Adjusted Spread on a Ginnie Mae MBS will usually be
higher than zero to the Treasury curve.
 Credit Spread Risk: The risk that the credit spread of a bond (extra yield
to compensate investors for taking default risk), which is inherent in the
fixed coupon, becomes insufficient compensation for default risk that has
later deteriorated. As the coupon is fixed the only way the credit spread
can readjust to new circumstances is by the market price of the bond
falling and the yield rising to such a level that an appropriate credit
spread is offered.
 Interest Rate Risk: The level of Yields generally in a bond market, as
expressed by Government Bond Yields, may change and thus bring about
changes in the market value of Fixed-Coupon bonds so that their Yield to
Maturity adjusts to newly appropriate levels.
 Liquidity Risk: There may not be a continuous secondary market for a
bond, thus leaving an investor with difficulty in selling at, or even near to,
a fair price. This particular risk could become more severe in developing
markets, where a large amount of junk bonds belong, such as India,
Vietnam, Indonesia, etc.
 Supply Risk: Heavy issuance of new bonds similar to the one held may
depress their prices.
 Inflation Risk: Inflation reduces the real value of future fixed cash flows.
An anticipation of inflation, or higher inflation, may depress prices
immediately.
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 Tax Change Risk: Unanticipated changes in taxation may adversely
impact the value of a bond to investors and consequently its immediate
market value.
Corporate bond indices
Corporate bond indices include the Barclays Corporate Bond Index, S&P U.S.
Issued Investment Grade Corporate Bond Index (SPUSCIG), the Citigroup US
Broad Investment Grade Credit Index, the JPMorgan US Liquid Index (JULI),
and the Dow Jones Corporate Bond Index.
Corporate bond market transparency
Speaking in 2005, SEC Chief Economist Chester S. Spatt offered the following
opinion on the transparency of corporate bond markets:
Frankly, I find it surprising that there has been so little attention to pre-trade
transparency in the design of the U.S. bond markets. While some might argue
that this is a consequence of the degree of fragmentation in the bond market, I
would point to options markets and European bond markets-which are similarly
fragmented, but much more transparent on a pre-trade basis.
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