Investments explained: the corporate bond

The investment world has many familiar and less familiar terms. Stocks, bonds or futures, for example. But what exactly do they all mean? In a series, we explain the characteristics and genesis of the various asset categories. In this episode, Odette Mutsaers (Portfolio Manager of Credits at APG) discusses the corporate bond.

What it is

A corporate bond - credit in jargon - is simply a loan issued by a company. “Large investors distinguish between two parties that can issue corporate bonds. This can be done by companies such as ASML, AkzoNobel and Alliander or by banks,” Mutsaers says.

A distinction is also made between so-called “Investment Grade” and “High Yield” companies. “The former have a somewhat higher credit risk than, say, a government, but still have a good credit rating. So the probability that such a company will repay its bond is relatively high. These types of companies have often been in business for a long time, have stable cash flows and have shown in the past that they meet their financial obligations. With High Yield companies, the likelihood of the bondholder getting their money back is considered somewhat lower, for example because the company is relatively small or operates in a sector with a bit more uncertainty.” 

Similarities to government bond

The corporate bond has many similarities to the government bond. “With corporate bonds, too, a large amount is often raised, of between 500 million and 3 billion euros. These are divided into smaller parts. So when an investor buys such a part, it lends money to the company and thus becomes a bondholder. This means that the company owes the investor (semi-)annual interest. After the term of the bond, the investor recovers the money lent. It is also possible to resell the bond on the market, just like a government bond.” 

Many companies issue stocks to raise money, but many more issue bonds for that purpose. “They do that, for example, to expand their business, make an acquisition or they spend it on research and the development of new products. A company has revenues, of course, but sometimes they are not enough or do not come in time to cover certain expenses. Bonds offer a solution in that case.”

Like government bonds, corporate bonds have different maturities. “A short-term corporate bond has a maturity of about two to five years. For medium-term corporate bonds, it is about seven to ten years and for long-term ones, fifteen to twenty years. This puts the maturity of corporate bonds on the short side compared to government bonds. Those sometimes only have to be repaid after 50 years.”

When did it originate?

The phenomenon of bonds dates back at least to Mesopotamia in 2,400 BC. For the first corporate bonds - as with the first shares - we have to go to the United East India Company (VOC). The interest rate (“coupon”) on those first corporate bonds from 1623 was 6.25 percent.

What else is involved?

Independent credit rating agencies determine the creditworthiness of companies. Analysts further assess that credit risk by doing fundamental analysis. In doing so, they look beyond just general economic conditions. “They analyze the results, follow the news surrounding the company, visit conferences and talk to management. Among other things, this gives them a good idea of the company’s strategy, which business units are making profits and what the main competitors are. Stock investors also look at companies this way. Although we pay more attention to the so-called downside risk: what is the risk of loss? What are the repayment terms if a company goes bankrupt? With stocks, we look more at a company's upside: what are the opportunities? What is the expected increase in value of shares?”

In addition to a company’s specific characteristics, interest rates are an important factor in determining the value of a corporate bond. “That is a derivative of the interest rate at which banks can borrow from a country’s central bank. The interest rate on the bond depends on its maturity, among other things. Repayment terms also play a role. A company may issue several types of bonds, with one offering a higher priority of repayment in the event of bankruptcy. Bondholders with a lower priority will want to see that risk offset with a higher interest rate. Finally, companies with higher credit risk often have to pay higher interest rates to compensate investors.”

When the central bank - in the case of the Netherlands, the European Central Bank - raises interest rates, new bonds become more attractive than existing ones. “On the new one, for example, the bondholder then gets 4 percent interest, and on the old one only 3 percent. The price of the old bond will then drop to make it as attractive again as the newly issued bonds with a higher interest rate. This mechanism applies to both government and corporate bonds.”