Sometimes, the term "corporate bonds" is used to include all bonds except those issued by governments in their own currencies. Strictly speaking, however, it only applies to those issued by corporations. The bonds of local authorities and supranational organizations do not fit in either category.
Corporate bonds are often listed on major exchanges (bonds there are called "listed" bonds) and ECNâ€™s like Bonds.com and MarketAxess, and the coupon (i.e. interest payment) is usually taxable. Sometimes this coupon can be zero with a high redemption value. However, despite being listed on exchanges, the vast majority of trading volume in corporate bonds in most developed markets takes place in decentralized, dealer-based, over-the-counter markets.
Some corporate bonds have an embedded call option that allows the issuer to redeem the debt before its maturity date. Other bonds, known as convertible bonds, allow investors to convert the bond into equity.
Corporate Credit spreads may alternatively be earned in exchange for default risk through the mechanism of Credit Default Swaps which give an unfunded synthetic exposure to similar risks on the same 'Reference Entities'. However, owing to quite volatile CDS 'basis' the spreads on CDS and the credit spreads on corporate bonds can be significantly different.
Compared to government bonds, corporate bonds generally have a higher risk of default. This risk depends, of course, upon the particular corporation issuing the bond, the current market conditions and governments to which the bond issuer is being compared and the rating of the company. Corporate bond holders are compensated for this risk by receiving a higher yield than government bonds. This comes to the conclusion that higher the risk, higher the profit. The key areas of risk involved in corporate bonds are as follows:
- Default Risk has been discussed above but there are also other risks for which corporate bondholders expect to be compensated by credit spread.
- Credit Spread Risk. The risk that the credit spread of a bond (extra yield to compensate investors for taking default risk), which is inherent in the fixed coupon, becomes insufficient compensation for default risk that has later deteriorated. As the coupon is fixed the only way the credit spread can readjust to new circumstances is by the market price of the bond falling and the yield rising to such a level that an appropriate credit spread is offered.
- Interest Rate Risk. The level of Yields generally in a bond market, as expressed by Government Bond Yields, may change and thus bring about changes in the market value of Fixed-Coupon bonds so that their Yield to Maturity adjusts to newly appropriate levels.
- Liquidity Risk. There may not be a continuous secondary market for a bond, thus leaving an investor with difficulty in selling at, or even near to, a fair price. This particular risk could become more severe in developing market, where a large amount of junk bonds belong, such as China, Vietnam, Indonesia, etc.
- Supply Risk. Heavy issuance of new bonds similar to the one held may depress their prices.
Inflation Risk. Inflation reduces the real value of future fixed cash flows. An anticipation of inflation, or higher inflation, may depress prices immediately.
- Tax Change Risk. Unanticipated changes in taxation may adversely impact the value of a bond to investors and consequently its immediate market value.