x Abu Dhabi, UAEFriday 28 July 2017

The building blocks of corporations

A definition of corporate bonds in this weeks in a word.

A corporate bond is any bond issued by a corporation. It may take the form of a plain-vanilla bond that pays a flat interest rate over a predetermined term or any other type of bond, including a convertible bond or a callable bond. As long as the bond is issued by a company and not a government, it qualifies as a corporate bond. As with any bond, investors who buy corporate bonds are lending money in exchange for future payments of interest and principal. A company may decide, for example, that it needs to build a new factory at a cost of Dh300 million. If the company - let's call it ABC Cement ? does not have enough cash on its books to foot the bill, the company may decide to issue a bond to raise the money.

ABC Cement would then go to a bank (or a group of banks) to act as underwriter and buy all the bonds and sell them to investors. Let's say, for example, that ABC issues Dh300m in the form of 300,000 bonds with a face value of Dh1,000 that pay 5 per cent interest per year. The underwriters may agree to buy them at Dh950 apiece, pocketing a nice profit in exchange for taking on the risk that they may not be able to sell all the bonds.

Investors in ABC's bond would be entitled to interest payments of Dh15m per year (or Dh50 per bond held). This is termed the bond's "coupon". At the end of the five years, ABC would have to pay back all of the Dh300m it originally borrowed. Ideally, its new plant would be up and working by then, and settling the bond at its maturity date wouldn't be a problem. If the company runs into trouble and cannot afford to pay bondholders, however, it is said to go into default. In that case, bondholders are entitled to force the company to sell off assets to make good on the bond. Corporate bonds take many different forms, depending on the needs of the company and the ease with which investment banks think they can sell them.

Some bonds are "callable", which means the company can decide to pay off bondholders before the maturity date (a provision that works in the bond issuer's favour). Others are "convertible", which means they can be changed into shares of the company's stock at a predetermined price when the maturity date is reached, giving bondholders an added potential for profit. The risk of default on corporate bonds varies considerably, but corporate debt is generally considered more risky than government debt. Corporate bonds thus tend to be priced lower (and tend to offer higher yields) than government bonds. @Email:afitch@thenational.ae