Corporate bonds are issued by companies and create a number of obligations the issuing companies must fulfill that are more stringent than when companies
issue stock. With corporate bonds, issuing companies pay bondholders interest semi-annually. For example, suppose you owned a bond that
paid a 5% coupon and you owned 10 bonds. For each bond you owned, you would receive $50 of interest each year and that interest income would
be split into two semi-annual payments of $25 each.
Below is a very basic introduction to individual corporate bonds. Please watch this video, which is a soup-to-nuts explanation of how corporate bonds work.
What is the face value of a bond?
The face value of a bond is $1,000. This is also known as the par value of a bond. At a bond's maturity date, the issuing company is obligated to repay the bondholder the face value of the bond.
How are corporate bonds quoted?
Individual corporate bonds are quoted as a percentage of their face value. Therefore, if a bond is quoted at 95.00, that bond is being valued at 95% of the $1,000 face value, or $950. Bonds that are quoted at less than their par value are said to be trading at a discount. Bonds trading above par value are said to be trading at a premium.
How much will I pay when I buy a bond?
Suppose you execute a trade today where you buy 10 bonds at a price of 90. Here's how the math works: First, each bond you bought cost $900. Since you bought 10 bonds, you will pay $9,000 in principal. In addition, you owe accrued interest since you will receive the full interest payment the next time the company pays interest. Bonds pay interest semi-annually on either the first or the fifteenth day of a month. For example, a bond may pay interest on a) February 15 and August 15 or b) on March 1 and September 1. Suppose you bought the 10 bonds on July 15 and it last paid interest on February 15. Let's assume the coupon of the bond is 5%, so the 10 bonds would pay the investor $500 of interest annually. In this example, interest will have accrued for five months plus two days, as interest accrues until the day immediately before the trade settles, which is two business days following the trade date. Interest typically accrues based on a 360-day year with 12 30-day months. Five months and two days of accrued interest is equal to: ((30 days*5 months)+2 days) / 360 = 42.2% of total annual interest or $211.11. On August 15, the investor who just bought the 10 bonds will receive $250 of interest, which is why she needed to pay the $211.11 in accrued interest to the selling bondholder.
What are covenants?
Bond covenants are effectively the do's and don'ts bond issuers must follow to stay in compliance with the bond indenture, a contract between issuer and bondholder. They govern the behavior of a company to help ensure bondholders are paid interest and receive a return of principal at maturity. An example of one financial covenant is the "Leverage Ratio," which limits the amount of debt a company can issue relative to its EBITDA, or earnings before interest, taxes, depreciation and amortization. Some investors believe covenants add 'complexity' to bonds, but, once investors understand them, they will see how they are in place for the benefit of bondholders. Be sure not to look for similar covenants in a stockholders' agreement, as you will never seem them in there.