Understanding a corporate bond’s prospectus

Corporate Bonds are an investment tool. Prospective investors interested in these securities have certain things they want to know about the bond related to the risk and return before investing. To help answer these questions, a corporate bond issuer will assemble a legal document known as a prospectus that should include everything an investor wants to know about the bond in order to make a wise decision.

Any investor who doesn’t want to lose his money will perform due diligence on a corporate bond before investing, and the prospectus is where most start that process. A corporate bond’s prospectus stays the same as when it was issued even when it is being sold on the aftermarket (from investor to investor). There are two different types of corporate bond prospectuses (much like there are 2 types of prospectuses for stocks):

Preliminary: Before an offering is finalized, the issuer puts together the first draft of the prospectus with everything that needs to go into it. Before it’s been finalized and approved for sale on the market, a prospectus is known as a preliminary prospectus.

Final: Once a corporate bond offering is set and finalized to be sold, a final version of the prospectus is issued that supersedes the preliminary. Investors will always want the final as there may have indeed been changes made from the preliminary – so this is the more significant of the two prospectuses when it comes to investor research.

The reason for and value of a prospectus

Because the prospectus is a comprehensive and detailed guide on how a bond works, it can be quite intimidating for new investors to tackle. However, investors must learn to understand and use prospectuses to guide their decisions. There are four key areas of a prospectus that investors must become familiar with and understand if they hope to have success investing in corporate bonds (ASIC, 2010; Sessoms, 2014):

Interest payments: One of the key areas that investors need to examine closely is the section that details the conditions and timing of interest payments (coupon payments) over the life (maturity term) of the corporate bond. This interest rate, often called the coupon rate, is predetermined and will affect the bond’s yield. That means this section is essential in order to examine and understand how much the corporate bond will return on the investment.

Key features, risks, & other indicators: A corporate bond has many other features besides the coupon rate that determine its risk. These should be in the prospectus and include things like the bond’s outlook in the market, plans for repayment upon maturity, the issuer’s credit rating, projections on price, what sort of liquidity the issuer enjoys, et cetera. All of the features, risks, and indicators included in a prospectus are important. Each issuer and bond is different, so each must be evaluated on its own in detail.

Call provisions: Sometimes issuers include provisions that allow them to make an early call on the corporate bond. That is, they are able to pay it off and stop making any more coupon payments that would have been paid until maturity at an early date. These are typically included in higher interest rate bonds as a way to let the issuer get out from under such burdensome debt if the market conditions change. A call provision allows them to take advantage of favorable conditions by paying off high-interest loans early and refinancing at a lower rate. Obviously this negatively impact investors’ projected returns, so understanding the call provisions and date included (if they are) in a corporate bond’s prospectus is absolutely essential to understand the bond’s likely true earning potential.

Date of maturity: A corporate bond’s total return is determined by its date of maturity. Until that time, the issuer will make coupon payments according to the terms in the prospectus. There are three basic types of bond life-spans: (1) short term which are around one to three years, (2) medium term which are around 5 years, and (3) long term bonds which can last up to 10 years or longer. The lifespan of a bond affects its vulnerability. Shorter-term bonds are less exposed to changes in the market. This means that short-term bonds usually enjoy lower volatility over medium and long-term bonds. However, medium and longer-term bonds can offer more interesting yields and most importantly each bond is unique and should be investigated on its own to ultimately determine its vulnerability to market conditions.

Without question, a corporate bond’s prospectus can be highly complex for prospective investors. However, the value of tackling and understanding all those complex features cannot be measured. Investing without due diligence will soon lead to investors losing money instead of making money. The key is to remember to break it down and tackle each section independently rather than trying to read the prospectus from start to finish. Once you understand a single section, move on. Overtime, investors who take this approach can and will develop key skills in evaluating a corporate bond’s investment-worthiness through its prospectus.

References:

Sessoms (2014) – http://budgeting.thenest.com/prospectus-bonds-21457.html

ASIC (2010) – https://www.moneysmart.gov.au/media/132057/investing-in-corporate-bonds.pdf