Corporate Bonds

In a notice to investors, the SEC explains that, "Companies use the proceeds from bond sales for a wide variety of purposes, including buying new equipment, investing in research and development, buying back their own stock, paying shareholder dividends, refinancing debt, and financing mergers and acquisitions."

A default on a municipal bond is a rare thing, but corporations can end up unable to pay the interest on their bonds or return the principal at maturity and thereby go into default. 

To protect bondholders from this, Congress passed the Trust Indenture Act of 1939. Under this act if a corporation wants to sell $5,000,000 or more worth of bonds that mature in longer than one year, they must do it under a contract or indenture with a trustee, who will enforce the terms of the indenture to the benefit of the bondholders. In other words, if the issuer defaults, the trustee can move to forcibly sell off the assets of the company, so bondholders can recover some of their money. The trustee is typically a large bank.

A corporate bond pays a fixed rate of interest to the investor, and that bond interest must be paid, unlike a dividend on stock that is paid only if the board of directors declares it from profits. We'll see that a bondholder doesn't suffer as much price volatility as a stock investor. But, unlike the owner of common stock, bondholders don't vote on corporate matters. The only time bondholders get to vote is if the corporation goes into bankruptcy. Creditors are offered various scenarios by the corporation, and the bondholders vote on the terms. In other words, the only time bondholders get to vote is when they wish they didn't.

Since bankruptcy is a concern, corporations often secure bonds by pledging assets like airplanes, government securities, or real estate. These bonds secured by collateral are called secured bonds.

The issuer of a secured bond pledges title of the assets to the trustee, who might end up selling them if the issuer gets behind on its interest payments. Investors who buy bonds attached to specific collateral are secured creditors, the most likely creditors to get paid should the company become insolvent.

Unsecured bonds are like personal loans from the local bank. Secured bonds are like the mortgage loans homeowners take out from the local bank.

In fact, if the collateral used is real estate, we call the secured corporate bond a mortgage bond. Just as a mortgage lender sometimes must foreclose/seize the home, the owners of mortgage bonds could seize the real estate backing the loan should the issuer get behind on their payments.

If the collateral is securities, we call it a collateral trust certificate. And if the collateral is equipment, such as airplanes or railroad cars, we call it an equipment trust certificate. Since secured bonds are usually the safest bonds issued by the company, they offer the lowest coupon payment, too.

Most corporate bonds are backed by a promise known as the "full faith and credit" of the issuer.

That's why we might want to see what S&P and Moody's say about an issuer's full faith and credit. If the credit is AAA, we won't be offered a large coupon payment. But if the issuer is rated right at the cut-off point of BBB (Baa for Moody's), then we demand a higher interest rate in exchange for buying bonds from an issuer just one notch above junk status. Regardless of the rating, if we buy a bond backed by the full faith and credit of an issuer, we are buying a debenture.

Debenture holders are general creditors with claims below those of the secured bondholders. In a bankruptcy, debenture holders must compete with other unsecured creditors of the company, e.g., suppliers with unpaid invoices. Therefore, debentures pay a higher yield than secured bonds, since they carry more risk.

Some bonds are guaranteed bonds, which means a party other than the issuer has promised to pay interest, principal, or both if the issuer of the bonds cannot. Often a parent company will guarantee the bonds issued by one of its smaller subsidiaries to improve the credit rating. A "guaranteed bond" does not imply the investor is guaranteed against loss. Outside of bank products backed by the FDIC, investors should never expect to be guaranteed against all investment risk. Being guaranteed against default is as good as it gets.

Subordinated debentures have a claim below debentures. Since these bonds have more credit/default risk, they pay a higher yield than debentures and secured bonds.

Beneath all creditors, stockholders make their claims on the company's assets. Preferred stockholders get preference, and common stock is always last in line. Common stock represents the lowest claim on a company's assets, which is why it is called the most "junior" security issued by a company.


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