Corporate bonds are fixed-income securities issued by industrial corporations, public utility corporations, or railroads to raise funds to invest in plant, equipment, or working capital. They can be broken down by issuer, in terms of credit quality (measured by the ratings assigned by an agency on the basis of probability of default), in terms of maturity (short term, intermediate term, or long term), or based on some component of the indenture (sinking fund or call feature).
All bonds include an indenture, which is the legal agreement that lists the obligations of the issuer to the bondholder, including the payment schedule and features such as call provisions and sinking funds. Call provisions specify when a firm can issue a call for the bonds prior to their maturity, at which time current bondholders must submit the bonds to the issuing firm, which redeems them (that is, pays back the principal and a small premium). A sinking fund provision specifies payments the issuer must make to redeem a given percentage of the outstanding issue prior to maturity.
Corporate bonds fall into various categories based on their contractual promises to investors. They will be discussed in order of their seniority. Secured bonds are the most senior bonds in a firm’s capital structure and have the lowest risk of distress or default. They include various secured issues that differ based on the assets that are pledged.
Mortgage bonds are backed by liens on specific assets, such as land and buildings. In the case of bankruptcy, the proceeds from the sale of these assets are used to pay off the mortgage bondholders. Collateral trust bonds are a form of mortgage bond except that the assets backing the bonds are financial assets, such as stocks, notes, and other high-quality bonds.
Finally, equipment trust certificates are mortgage bonds that are secured by specific pieces of transportation equipment, such as locomotives and boxcars for a railroad and airplanes for an airline.
Debentures are promises to pay interest and principal, but they pledge no specific assets (referred to as collateral) in case the firm does not fulfill its promise. This means that the bondholder depends on the success of the borrower to make the promised payment.
Debenture owners usually have first call on the firm’s earnings and any assets that are not already pledged by the firm as backing for senior secured bonds. If the issuer does not make an interest payment, the debenture owners can declare the firm bankrupt and claim any unpledged assets to pay off the bonds.
Subordinated bonds are similar to debentures, but, in the case of default, subordinated bondholders have claim to the assets of the firm only after the firm has satisfied the claims of all senior secured and debenture bondholders. That is, the claims of subordinated bondholders are secondary to those of other bondholders.
Within this general category of subordinated issues, you can find senior subordinated, subordinated, and junior subordinated bonds. Junior subordinated bonds have the weakest claim of all bondholders.
Income bonds stipulate interest payment schedules, but the interest is due and payable only if the issuers earn the income to make the payment by stipulated dates. If the company does not earn the required amount, it does not have to make the interest payment and it cannot be declared bankrupt.
Instead, the interest payment is considered in arrears and, if subsequently earned, it must be paid off. Because the issuing firm is not legally bound to make its interest payments except when the firm earns it, an income bond is not considered as safe as a debenture or a mortgage bond, so income bonds offer higher returns to compensate investors for the added risk.
There are a limited number of corporate income bonds. In contrast, income bonds are fairly popular with municipalities because municipal revenue bonds are basically income bonds.
Convertible bonds have the interest and principal characteristics of other bonds, with the added feature that the bondholder has the option to turn them back to the firm in exchange for its common stock. For example, a firm could issue a $1,000 face-value bond and stipulate that owners of the bond could turn the bond in to the issuing corporation and convert it into 40 shares of the firm’s common stock.
These bonds appeal to investors because they combine the features of a fixed-income security with the option of conversion into the common stock of the firm, should the firm prosper.
Because of their desirable conversion option, convertible bonds generally pay lower interest rates than nonconvertible debentures of comparable risk. The difference in the required interest rate increases with the growth potential of the company because this increases the value of the option to convert the bonds into common stock. These bonds are almost always subordinated to the nonconvertible debt of the firm, so they are considered to have higher credit risk and receive a lower credit rating from the rating firms.
An alternative to convertible bonds is a debenture with warrants attached. The warrant is an option that allows the bondholder to purchase the firm’s common stock from the firm at a specified price for a given time period.
The specified purchase price for the stock set in the warrant is typically above the price of the stock at the time the firm issues the bond but below the expected future stock price. The warrant makes the debenture more desirable, which lowers its required yield. The warrant also provides the firm with future common stock capital when the holder exercises the warrant and buys the stock from the firm.
Unlike the typical bond that pays interest every six months and its face value at maturity, a zero coupon bond promises no interest payments during the life of the bond but only the payment of the principal at maturity.
Therefore, the purchase price of the bond is the present value of the principal payment at the required rate of return. For example, the price of a zero coupon bond that promises to pay $10,000 in five years with a required rate of return of 8 percent is $6,756. To find this, assuming semiannual compounding (which is the norm), use the present value factor for 10 periods at 4 percent, which is 0.6756.
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