Corporate Bonds

Quick Answer

Corporate bonds pay semiannual interest on a $1,000 par value, are fully taxable at every level, and rank by seniority in liquidation: secured, then unsecured debentures, then subordinated debentures, then income bonds. All debt outranks all equity regardless of the labels used.

The rest of this lesson breaks bonds down by rating (investment-grade versus junk), by feature (convertible, zero-coupon, sinking fund), and by legal priority. Each distinction shows up as its own exam question type.

What Are Corporate Bonds?

Corporations issue bonds to raise debt capital. Corporate bonds pay semiannual fixed interest (coupon) and return principal at maturity.

Standard par value: $1,000

Subject to credit (default) risk: issuer may fail to pay interest or principal

Interest is taxable at all levels (federal, state, local)

Rated by Moody's, Standard & Poor's (S&P), and Fitch for credit quality

Bonds are negotiable instruments; their negotiability allows them to be transferred or sold to another investor in the secondary market before maturity

What Is the Indenture?

The indenture is the formal written contract between the issuer and the bondholders. It is sometimes called the trust agreement or deed of trust. The indenture spells out:

Coupon rate, payment dates, maturity

Collateral (if any) backing the bond

Call provisions, sinking fund provisions, conversion features

Covenants the issuer must meet (financial ratios, restrictions on additional debt)

The trustee who represents bondholder interests

What Separates Investment-Grade from High-Yield Bonds?

Investment-grade bonds: Rated BBB- (S&P) or Baa3 (Moody's) or higher; lower yield; lower default risk

High-yield (junk) bonds: Rated below BBB-/Baa3; higher yield; higher default risk; typically issued by lower-rated or financially weaker companies

How Do S&P and Moody's Ratings Compare?

AAA: Broadly comparable Moody's grade Aaa; S&P description Highest quality, minimal risk

AA: Broadly comparable Moody's grade Aa; S&P description High quality

A: Broadly comparable Moody's grade A; S&P description Upper medium grade

BBB: Broadly comparable Moody's grade Baa; S&P description Medium grade (lowest investment-grade tier)

BB: Broadly comparable Moody's grade Ba; S&P description Speculative

B: Broadly comparable Moody's grade B; S&P description Highly speculative

CCC: Broadly comparable Moody's grade Caa; S&P description Poor standing, may default

CC: Broadly comparable Moody's grade Not an exact match; S&P description Highly vulnerable; default expected

C: Broadly comparable Moody's grade Not an exact match; S&P description Highly vulnerable to nonpayment; lower relative recovery

D: Broadly comparable Moody's grade Not an exact match; S&P description In default or breach of the promised obligation

Moody's lowest categories differ: Ca means likely in or very near default, while C means typically in default. Do not treat the agencies' lowest ratings as exact equivalents. Fitch also publishes its own definitions.

S&P uses + and - modifiers from AA through CCC; Moody's uses 1, 2, 3 from Aa through Caa. The + or 1 indicates the highest tier within the category.

Exam Tip: Gotchas

The BBB-/Baa3 line separates investment-grade from junk. Worth remembering.

Ratings measure credit (default) risk only; they do not measure liquidity, interest-rate risk, or suitability for any particular investor.

A rating and collateral answer different questions. The rating signals how likely a default is. Collateral (a secured bond) improves what holders recover after a default. A AAA debenture, which has no collateral, is still safer than a B-rated mortgage bond.

How Do Yield Spreads Move With Economic Stress?

The yield spread is the extra yield a high-yield (junk) bond pays over a comparable Treasury. During periods of economic stress, spreads widen significantly as investors demand more compensation for default risk and rotate away from credit. In healthy economies, spreads narrow.

How Do Convertible Bonds Work?

Can be converted into a fixed number of shares of the issuer's common stock

Offer a lower coupon than comparable non-convertible bonds because the conversion feature has value

Give investors equity upside while still receiving bond interest payments

The bondholder profits from conversion once the shares received are worth more than the bond itself, not merely once the stock clears the conversion price

Exam Tip: Gotchas

Convertible bonds pay lower coupons than non-convertible bonds. The conversion privilege compensates for the lower interest.

How Do Zero-Coupon Bonds Work?

Pay no periodic interest; issued at a deep discount to par value

The difference between purchase price and par value represents the investor's return

Phantom income: Even though the investor receives no cash until maturity, the IRS requires annual tax on accrued interest (the "accretion" of the discount)

Popular in tax-deferred accounts (like IRAs) where phantom income is not an issue

Exam Tip: Gotchas

Zero-coupon bond holders owe taxes every year on phantom income even though they receive no cash until maturity.

What Are Secured (Mortgage) Bonds?

Backed by specific assets (real estate, equipment)

Highest priority among bonds in liquidation

What Are the Types of Unsecured Bonds?

Debenture: Backed only by issuer's general creditworthiness (unsecured); below secured bonds in liquidation

Subordinated Debenture: Unsecured and junior to regular debentures; still senior to stockholders

Income (adjustment) bonds: Pay interest only if the issuer earns sufficient income; lowest priority among bonds. A skipped interest payment on an income bond is not a default, unlike a missed payment on a standard fixed-coupon bond.

What Is a Sinking Fund Provision?

A sinking fund is a provision in the bond indenture that requires the issuer to set aside money periodically to retire portions of the debt before maturity. This reduces the issuer's repayment burden at maturity and lowers the bond's credit risk.

Exam Tip: Gotchas

A sinking fund benefits investors by lowering credit risk and providing some price support, but it also caps upside: bonds called at par cannot continue to appreciate above par.

Investors may face reinvestment risk when their bonds are called early under a sinking fund.

How Do the Bond Types Compare?

Secured (mortgage) bonds: Backing Specific assets (real estate, equipment); Priority in Liquidation Highest among bonds

Debentures: Backing Issuer's general creditworthiness (unsecured); Priority in Liquidation Below secured

Subordinated debentures: Backing Unsecured; junior to debentures; Priority in Liquidation Below debentures

Income (adjustment) bonds: Backing Pay interest only if issuer earns sufficient income; Priority in Liquidation Lowest

What Is the Liquidation Priority, Most Senior to Most Junior?

1st: Secured creditors (mortgage bondholders)

2nd: Unsecured creditors (debenture holders)

3rd: Subordinated debenture holders

4th: Preferred stockholders

5th: Common stockholders

Key Rule: Debt always comes before equity, regardless of descriptive words. A "junior subordinated debenture" still beats a "senior preferred stock." Income bonds, the lowest-priority bond type, rank below subordinated debentures but still ahead of preferred and common stock, since debt always beats equity.

Exam Tip: Gotchas

"Senior preferred stock" never comes before subordinated debt. All debt beats all equity, period.

What Should You Check on Exam Day?

Standard corporate bond par is $1,000; interest is taxable at all levels

Investment-grade floor is BBB-/Baa3; below that is high-yield (junk)

Convertible bonds pay lower coupons because the conversion feature has value

Zero-coupon bonds create phantom income taxed annually despite no cash received

Liquidation order: secured, then unsecured debentures, then subordinated debentures, then income bonds, then preferred stock, then common stock

A sinking fund lowers credit risk but caps upside because bonds get called at par