4.4 Corporate Bonds

Corporate bonds are debt securities issued by corporations to raise capital. They offer higher yields than government securities but carry additional credit risk.

Corporate Bond Basics

Issuer: Corporations (public and private)

Maturities: 1-30 years (typically 5-10 years)

Interest: Usually semi-annual coupon payments

Trading: Most trade over-the-counter (OTC)

Credit Risk: Varies widely by issuer

Tax Treatment: Fully taxable (federal, state, local)

Secured vs. Unsecured Bonds

Secured Bonds (Backed by Collateral)

Mortgage Bonds: Collateral, real property (real estate, land); Lower yield

Equipment Trust Certificates: Collateral, equipment (railroads, airlines, ships); Lower yield

Collateral Trust Bonds: Collateral, financial assets (stocks, bonds); Lower yield

Advantage: If issuer defaults, bondholders can claim specific assets.

Unsecured Bonds (Debentures)

Senior Debentures: Paid before subordinated debt; Moderate yield

Subordinated Debentures: Paid after senior debt; Higher yield

Debentures are backed only by the issuer's creditworthiness and general assets, no specific collateral.

Seniority Hierarchy (Liquidation Order)

If a company goes bankrupt, claims are paid in this order:

1 (Highest): Secured bondholders (to extent of collateral)

2: Senior unsecured bondholders

3: Subordinated bondholders

4: Preferred stockholders

5 (Lowest): Common stockholders

Key Point: Bondholders are paid before stockholders in bankruptcy.

Special Bond Features

Callable Bonds

Call Feature: Issuer can redeem before maturity

Call Protection: Period when bond cannot be called

Call Premium: Amount above par paid at call

Benefit: Issuer can refinance at lower rates

Risk: Limits investor upside; reinvestment risk

When Called: Interest rates have fallen, issuer refinances at lower rate, investor loses high-coupon bond.

Putable Bonds

Put Feature: Investor can force early redemption

Benefit: Protection against rising rates

Yield: Lower than comparable non-putable bonds

When Exercised: Interest rates have risen, investor "puts" bond back to get cash to reinvest at higher rates.

Convertible Bonds

Conversion: Can exchange for common stock

Conversion Ratio: Number of shares per bond

Conversion Price: Implied price per share

Yield: Lower than non-convertible (equity upside)

Best When: Stock price rises significantly

Example:

- Bond converts to 40 shares (conversion ratio)

- $1,000 par divided by 40 shares = $25 conversion price

- If stock rises above $25, conversion becomes attractive

Zero-Coupon Bonds

Interest: None, sold at deep discount

Interest Rate Risk: Maximum (long duration)

Reinvestment Risk: Zero

Taxation: Annual phantom income tax

Credit Ratings

Credit ratings assess the probability of default:

AAA / Aaa: Prime; Lowest risk

AA+, AA, AA- / Aa1, Aa2, Aa3: High grade; Very low

A+, A, A- / A1, A2, A3: Upper medium; Low

BBB+, BBB, BBB- / Baa1, Baa2, Baa3: Investment grade cutoff; Moderate

BB+, BB, BB- / Ba1, Ba2, Ba3: Speculative; Higher

B+, B, B- / B1, B2, B3: Highly speculative; High

CCC and below / Caa and below: Substantial risk; Very high

D / C: In default; Maximum

Investment Grade: BBB-/Baa3 and above. High Yield (Junk): BB+/Ba1 and below

Credit Spread

Credit spread = Corporate bond yield minus Treasury yield of same maturity

Widening: Increased credit concern; more risk aversion

Narrowing: Improved confidence; more risk appetite

Credit spreads typically widen during recessions and narrow during expansions.

In Practice: How Investment Advisers Apply This

Portfolio construction:

- Use investment-grade corporates for income with moderate risk

- Consider high-yield for aggressive income strategies

- Convertibles for equity-like upside with bond-like downside

- Match credit quality to client risk tolerance

Risk considerations:

- Callable bonds have reinvestment risk

- Subordinated debt has higher loss severity in default

- Credit spreads indicate market sentiment about default risk

On the Exam

The Series 65 exam tests your understanding of:

1. Secured vs. unsecured: Mortgage bonds, debentures

2. Seniority: Secured > Senior unsecured > Subordinated > Equity

3. Callable bonds: Benefit issuer; reinvestment risk for investor

4. Convertible bonds: Exchange for stock; lower coupon

5. Credit ratings: Investment grade (BBB-/Baa3 and above) vs. junk

Common formats include identifying bond types and understanding callable/convertible features.

Key Takeaways

- Secured bonds are backed by specific collateral; debentures are unsecured

- Seniority: Secured > Senior > Subordinated > Preferred > Common

- Callable bonds benefit the issuer (can refinance at lower rates)

- Putable bonds benefit the investor (can sell back if rates rise)

- Convertible bonds have lower yields but stock upside potential

- Investment grade: BBB-/Baa3 and above; Junk: BB+/Ba1 and below

- Credit spreads widen when risk increases; narrow when confidence returns

- All corporate bond interest is fully taxable