2. What is a corporate bond?
Stability and known cash flows
A corporate bond is a loan to a company and at the same time a security that can be traded on the capital market. When a company needs loan financing there are two main options: bank loans via the banking system or corporate bonds via the capital market. A company’s financing often comes from both bank loans and corporate bonds. When a company wants to finance itself via a corporate bond, it has preferences regarding how much capital is borrowed and the maturity, while the interest shown by the investor community affects the interest rate and final terms of the bond. The terms of the bond specify, for example, whether or not there are collateral and pledges, and the bond’s priority in relation to other liabilities in the issuing company.
Corporate bonds are issued and initially traded on the primary market and then traded on the secondary market. In the primary market the terms can change while the price remains fixed. In the secondary market the terms are fixed and price is the factor that changes with the market’s view of the risk associated with the bond. The secondary market makes it possible to buy and sell bonds before they mature.
Simply put, in the primary market the investor pays the company and receives the bond. The investor then receives a coupon (interest) until the bond matures and on the maturity date the company repays 100% of the loan to the investor and the last coupon. The coupon is usually paid quarterly, semi-annually or annually.
Why corporate bonds?
The company’s perspective
The bond market offers an alternative source of financing alongside banks and stock markets. The banks’ strict new capital adequacy rules often limit their corporate lending. In many cases a bond can be a better option for shareholders than a new share issue that dilutes shareholders’ holdings.
Although the bond market can sometimes be perceived as costly for companies, it can be a way of facilitating an investment that a company would not otherwise be able to make if it does not have enough equity and bank loans to acquire an operation or property, for example. In that situation a corporate bond is a necessary form of financing for the company, even if it is more expensive than a bank loan.
Furthermore, the bond market can lend for a longer period than a bank and this gives companies scope to carry out projects. The bond market increases companies’ financing flexibility.
Cost of Capital – WACC
WACC is a theoretical model for calculating the optimal financing structure for a company. The lower the value, the less expensive the financing for the company. According to the WACC model, it is not optimal for a company to conduct business without, or with too much, financing through loans. For example, the model shows that large Nordic industrial companies should have moderate borrowing that equates to a credit rating of between A3 and Baa2.
The investor’s perspective
Corporate bonds have several attractive features. They always carry a lower risk than shares in a company and the cash flow is known in advance because the size of the coupon and the price of the bond on maturity are specified in the bond indenture. Pledges and the fact that bond investors have priority over shareholders in claims on a company’s assets are factors that protect the value of a bond. Unlike shares, bonds do not require companies to show growth or win market share to deliver their return; instead it is enough that the company can repay the bond on maturity. Corporate bonds also add diversification to a portfolio of shares and commodities.
Many issuers in the Nordic corporate bond market are not listed and, as a result, the bond market offers investors an opportunity to broaden their exposure. Non-listed companies do not have to be as driven by quarterly reporting, which can create more of a long-term approach.
We can see from the figure above that corporate bonds carry a lower risk than shares because market fluctuations are smaller for corporate bonds. Furthermore, the market for corporate bonds is not exposed to the various machines and trading robots that are typical of stock markets and currency markets.
The issuance process
A company wanting to issue a corporate bond turns to an arranger, generally a securities broker or bank, for assistance with structuring the bond and raising capital. The arranger usually handles both parts. Both the legal process and the raising of capital often take longer the first time a company carries out a bond issue. This is because a more thorough review of the company (due diligence) has to be carried out and because the company is unknown to the market. The legal information is accompanied by an investor presentation in which the issuer (the borrower) presents its business strategy, financial status and prospects. The issuer then undertakes to report its accounts on a continuous basis.
Corporate bonds can be registered on a stock exchange but are rarely traded electronically. Instead, bonds are usually traded OTC (over the counter) and generally over the phone. The arranger is responsible for maintaining a secondary market for the bond. The bond’s payments are made via Euroclear in Sweden and VPS in Norway. Most corporate bonds have an agent to represent the interests of the bondholders.
In order to increase transparency throughout the securities market, a new directive came into effect in the EU on 3 January 2018: MiFID II. This regulatory framework means, for example, that the price and volume must be registered with Finansinspektionen (Sweden’s financial supervisory authority) in Sweden or its equivalent in other EU countries, the day after a transaction has taken place.