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Corporate bonds: Why companies pay back money at different interest rates

by , 11 August 2014

If you look at the bond market, the safest types of bonds you can invest in are government bonds. This is because governments rarely go bust. And if things get tough, governments can always resort to printing more money.

But it's not quite as easy for companies. African Bank bonds are a perfect example of what high risk can do to corporate bonds.

Let's take a closer look at what determines how much companies pay for borrowing money…

Corporate bonds have varying levels of risk

Compared with government bonds, corporate bonds are riskier. What this means is companies can’t borrow money as cheaply as governments with bonds.

It costs companies more to borrow money than governments.

It all comes down to individual companies. And their associated risk, Phil Oakley in Money Week explains.

Take Johnson & Johnson, a massive multinational company. It can borrow money almost as cheaply as the US government. Johnson & Johnson dominate their market and its financials reflect this.

So the interest rate on Johnson & Johnson bonds is very low.

The more debt a company takes on, the more risky it becomes. And that means they have to pay more to borrow as a result.

The story of African Bank’s bonds

African Bank is an unsecured lender. It operates in a different way to most banks – it doesn’t take deposits.

Most banks use the money from deposits to work for them, but African Bank doesn’t have this option. It has had to rely heavily on the bond market for funds.

Last week saw shares in African Bank plunge over 90%. This followed an announcement from the company revealing that its losses has spiralled out of control. And it revealed its CEO had stepped down.

So what effect did this have on its bonds?

Its bond due to expire in February 2017 plummeted in value, says IOL. Not only that, the yield surged to 47.49%. That’s a rise of “more than 29%” from before the company’s announcement.

This movement in the bond prices just goes to show how the perceived risk of African Bank bonds changed. With the bank in severe financial difficulty, bond investors showed that they saw the chance of the bank not paying back the money owed much higher.

So there you have it, why companies pay back money at different interest rates.

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Corporate bonds: Why companies pay back money at different interest rates
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