Understanding Corporate Bonds: How They Work and Their Benefits

Corporate bonds are a crucial tool for companies seeking to raise capital for various needs, ranging from financing ongoing operations to funding large-scale projects. These debt securities allow companies to borrow money from investors by obliging them to repay the loan amount (principal) at a later date, while also paying a fixed or floating rate of interest.

The Fundamentals of Corporate Bonds

A corporate bond is essentially a loan given by an investor to a corporation. When a company issues a bond, it is borrowing money from the bondholders and promising to repay the principal and interest over a specified period. The company issues these bonds to raise capital, and in return, bondholders receive periodic interest payments and the principal at maturity.

Key Terms and Concepts

Bonds are essentially a debt instrument in which the buyer lends money to the borrower, which is typically a government entity or a corporation. There is always a fixed maturity date at which the bond’s principal must be returned to the bondholder. However, some bonds may also be callable, meaning the issuer can choose to redeem the bond before the maturity date.

Additionally, if a bond is traded in a secondary market, the bondholder can sell it before maturity. The price of the bond in the secondary market can fluctuate based on changes in interest rates and the issuer's creditworthiness since the date of purchase.

Another critical point to remember is that in the event of bankruptcy, bondholders have the priority over stockholders in receiving payment. Therefore, corporate bonds are considered a safer type of investment compared to stocks.

Types of Corporate Bonds

There are various types of corporate bonds, each with its own characteristics and advantages. Here are some common types:

1. Security of Bonds

Bonds with security are backed by an underlying asset. This can provide a layer of protection for investors, as the asset can be liquidated to cover the debt if the company defaults.

2. Mortgage Bonds

Mortgage bonds are secured by real estate or a group of real estate properties, which serve as collateral for the bond issue. This type of bond can be a safer investment as the real estate asset can be liquidated in the event of default.

3. Collateral Trust Bonds

These bonds are secured by specific assets that are held in a trust and managed by a third party. The assets can include equipment, property, or other valuable items.

4. Equipment Trust Certificates

These are a type of bond that is backed by specific equipment and are often used in the financing of large machines or equipment used in industries such as manufacturing or transportation.

5. Debenture Bonds

Debenture bonds are unsecured bonds supported only by the general creditworthiness of the issuer. They are issued based on the borrower's credit rating.

6. Convertible Debentures

Convertible debentures can be converted into equity shares of the issuing company at a specified price and date. This feature can make the bond a dual-purpose investment.

7. Guaranteed Bonds

Guaranteed bonds are backed by a third party, such as a government or a financial institution, which guarantees the bond's repayment. This can enhance the security of the investment.

Note: High Yield Corporate Bonds are generally referred to as “junk bonds,” which offer higher yields to compensate for higher credit risk. These are often issued by companies with lower credit ratings.

Corporate Bond Market Segments

The market for long-term corporate debt is divided into two main segments:

1. Public Sector Units (PSUs)

PSUs include public financial institutions that issue bonds for various purposes, including infrastructure development and other public sector projects. These bonds can be further classified into taxable and tax-free bonds. Tax-free bonds are primarily issued by PSUs in the infrastructure sector, which can offer tax advantages to investors.

2. Private Corporate Sector

Bonds issued by the private corporate sector are essential for companies looking to fund growth and expansion. These bonds can be structured with embedded options, such as floating-rate interest conversion options, to provide additional flexibility to both issuers and investors.

Specified Bonds and Capital Gains Tax Benefits

There are certain specified bonds in India, such as those issued by the National Highway Authority of India (NHAI), the National Bank for Agriculture and Rural Development (NABARD), and the National Housing Bank (NHB). These bonds qualify as instruments that can help save on capital gains tax under Section 54 EC of the Indian Income Tax Act. Investing in such bonds can allow investors to reduce their tax liability on long-term capital gains from land and buildings.