How do corporate bonds work?
The corporate bond market is an important source of funding for many Australian companies, while also presenting investment opportunities for individuals and institutions.
Companies issue bonds, known as corporate bonds, to raise money to finance their business activities.
Investors that buy the bonds normally receive regular interest payments from the issuing company throughout the pre-determined lifetime of the bonds.
When you invest in corporate bonds you’re essentially making a loan to the company, rather than getting an ownership stake, which you get through shares.
Corporate bonds usually have a face value of $100 when issued. That amount is repaid upon the ‘maturity date’ when the bond expires.
Between the issue date and the maturity date investors will receive regular interest payments at a rate known as the ‘coupon’.
If you invest $10,000 in bonds that have a coupon of 5%, for example, you would receive $500 a year in pre-tax interest payments.
Corporate bonds tend to pay a higher rate of interest than government bonds as they are more risky.
Fixed or floating
Bonds can pay either a fixed or floating rate of interest. A fixed rate of interest means you’ll receive the same amount of interest every year until the bond matures.
A floating rate of interest means the amount you receive is subject to change from one payment period to the next.
Fluctuations in benchmark interest rates could cause the floating rate to change. If the benchmark goes up, so too will the interest you receive and vice versa.
How rates are determined
A company issues bonds with an amount in mind that it wants to raise and hires investment banks to set an appropriate rate of interest in order to attract investors.
In Australia the coupon rate is likely to be based on the interest rate environment at the time, reflected by the official cash rate set by the Reserve Bank of Australia (RBA), bond market sentiment and the financial position of the issuing company.
A company that is perceived to be at a higher risk of default, by failing to maintain interest payments, will typically have to pay a higher rate of interest than a company that is perceived to be safer.
This also means that higher yielding bonds, those that pay a higher rate of interest, are generally more risky to invest in than lower yielding bonds.