Managing Credit Risk in Corporate Bond Portfolios : A Practitioner's ...

CHAPTER 3The Corporate Bond MarketIn this chapter, I describe the features of corporate bonds and identify therisks associated with investment in corporate bonds. I then discuss thepractical difficulties related to the trading of corporate bonds as opposed togovernment bonds arising from increased transaction costs and lack oftransparent pricing sources. I highlight the important role played by corporatebonds in buffering the impact of financial crises and examine the relativemarket size and historical performance of corporate bonds. Finally, Iprovide some justification as to why the corporate bond market is an interestingasset class for the reserves portfolio of central banks and for pensionfunds.FEATURES OF CORPORATE BONDSCorporate bonds are debt obligations issued by private and public corporationsto raise capital to finance their business operations. The major corporatebond issuers can be classified under the following categories: (1)public utilities, (2) transportation companies, (3) industrial corporations,(4) financial services companies, and (5) conglomerates. Corporate bondsdenominated in U.S. dollars are typically issued in multiples of $1,000 andare traded primarily in the over-the-counter (OTC) market.Unlike owners of stocks, holders of corporate bonds do not have ownershiprights in the corporation issuing the bonds. Bondholders, however,have priority on legal claims over common and preferred stockholders onboth income and assets of the corporation for the principal and interest dueto them. The promises of corporate bond issuers and the rights of investorswho buy them are set forth in contracts termed indentures. The indenture,which is printed on the bond certificate, contains the following information:the duties and obligations of the trustee, all the rights of the bondholder,how and when the principal will be repaid, the rate of interest, the descriptionof any property to be pledged as collateral, and the steps the bondholdercan take in the event of default.23