Corporate Bond Fundamentals
Before diving into specific bond types and strategies, you need a solid grasp of how corporate bonds are structured, what risks they carry, and how call provisions change the game for both issuers and investors.
Basic Structure and Characteristics
A corporate bond is a debt instrument issued by a corporation to raise capital. When you buy a bond, you're lending money to the issuer in exchange for periodic interest payments and the return of your principal at maturity.
| Feature | Detail |
|---|---|
| Par value (face value) | $1,000 per bond |
| Coupon rate | Fixed or variable annual interest rate stated on the bond |
| Interest payments | Semiannual (every 6 months) unless otherwise stated |
| Maturity | Date the issuer repays par value |
| Form of ownership | Book-entry (electronically registered) |
| Settlement | T+1 (regular way, effective May 28, 2024) |
| Quotation | Percentage of par (e.g., 98.50 = $985.00) |
Maturity classifications:
- Short-term: Less than 5 years
- Intermediate-term: 5 to 12 years
- Long-term: More than 12 years
Exam Tip: Gotchas
Bond prices are quoted as a percentage of par, not in dollars. A quote of 98.50 means 98.50% of $1,000 = $985.00. A quote of 102 means $1,020.00. The exam expects you to convert between quote format and dollar amounts quickly.
The Bond Indenture and Trustee
- A bond indenture (trust indenture) is the legal contract between the issuer and bondholders
- It specifies all terms: coupon rate, maturity date, call provisions, covenants, and collateral
- A trustee (typically a bank or trust company) is appointed to act on behalf of bondholders and enforce the indenture terms
- Required under the Trust Indenture Act of 1939 for public bond offerings over $50 million
The trustee's job is to protect bondholders' interests. If the issuer violates any indenture terms, the trustee takes action on behalf of all bondholders.
Exam Tip: Gotchas
Bearer bonds are no longer issued. All corporate bonds today are book-entry (electronically registered). If an exam question mentions bearer bonds, the answer involves historical context, not current practice.
Risks of Corporate Bonds
Every bond carries multiple types of risk. Understanding which risks apply to which situations is frequently tested.
| Risk | Description | Key Relationship |
|---|---|---|
| Interest rate risk (market risk) | Bond prices move inversely to interest rates | Longer maturities = greater sensitivity |
| Credit risk (default risk) | Risk the issuer cannot make payments | Measured by bond ratings |
| Call risk | Early redemption when rates fall | Forces reinvestment at lower rates |
| Reinvestment risk | Coupons reinvested at lower prevailing rates | Highest when rates are falling |
| Inflation risk (purchasing power risk) | Fixed payments lose real value | Worst for long-term, fixed-rate bonds |
| Liquidity risk | Some bonds trade infrequently | Wider bid-ask spreads |
Exam Tip: Gotchas
Interest rate risk and reinvestment risk move in opposite directions. When rates rise, bond prices fall (bad for the holder), but reinvested coupons earn more (good). When rates fall, bond prices rise (good), but reinvested coupons earn less (bad). The exam loves testing this inverse relationship.
Call Provisions
A callable bond gives the issuer the right to redeem the bond before maturity. This is an advantage for the issuer and a disadvantage for the investor.
- Call premium: The amount above par the issuer pays to call the bond (e.g., 102 = $1,020)
- Call protection period: The initial period during which the bond cannot be called (e.g., 10 years of call protection on a 30-year bond)
- Issuers call bonds when interest rates fall so they can refinance at lower rates
- Callable bonds offer higher coupon rates than comparable non-callable bonds to compensate for call risk
Make-whole call provision:
- Requires the issuer to pay the bondholder the present value of all remaining cash flows discounted at a specified rate
- Designed to make the bondholder "whole"; effectively removes the incentive to call early
- More protective for bondholders than a standard call provision
Exam Tip: Gotchas
When a bond is callable and trading at a premium, the relevant yield measure is yield to call (YTC) because the issuer has an incentive to call. Yield to worst is the lowest of YTC and yield to maturity (YTM). Always use yield to worst when evaluating callable bonds trading at a premium.
Call protection protects the investor, not the issuer. The longer the call protection period, the more valuable the bond is to the holder.
Think of it this way: When interest rates drop, the issuer is essentially paying above-market rates on their existing bonds. Calling the bond lets them "refinance" at today's lower rate. The investor gets their principal back (plus a small call premium), but now faces reinvesting in a lower-rate environment. That is where call risk and reinvestment risk overlap.