2.8 Corporate Bonds

Corporate bonds are debt securities issued by companies to raise capital for business operations, expansion, or refinancing existing debt. They typically offer higher yields than government bonds but carry more risk. Understanding the various types and features of corporate bonds is essential for the SIE exam.

What Are Corporate Bonds?

When a corporation needs to borrow money, it can issue bonds to investors. In return, the company promises to:

1. Pay periodic interest (usually semi-annually)

2. Repay the principal at maturity

Corporate bonds are senior to stock in the capital structure - bondholders get paid before stockholders in bankruptcy.

Secured vs. Unsecured Bonds

Corporate bonds are classified by whether they are backed by collateral:

Secured Bonds

Secured bonds are backed by specific company assets as collateral. If the company defaults, bondholders can claim the collateral.

Mortgage bonds: Collateral - Real estate/property; Risk Level - Lower

Equipment trust certificates: Collateral - Equipment (trains, planes, etc.); Risk Level - Lower

Collateral trust bonds: Collateral - Securities held by trustee; Risk Level - Lower

Key Point: Secured bonds offer lower yields because they are safer - the collateral provides protection.

Unsecured Bonds (Debentures)

Debentures are unsecured bonds backed only by the company's promise to pay and its general creditworthiness.

- No specific collateral

- Higher yields to compensate for higher risk

- Rank below secured bonds in bankruptcy

Subordinated Debentures

Subordinated debentures rank even lower than regular debentures. They are paid only after senior debt is satisfied.

Priority Order in Bankruptcy:

1. Secured bondholders (first claim on collateral)

2. Senior unsecured bondholders (debentures)

3. Subordinated bondholders

4. Preferred stockholders

5. Common stockholders (last)

Bond Features

Callable Bonds

Callable bonds give the issuer the right to redeem the bonds before maturity at a specified call price.

Call price: Usually par plus a premium (e.g., $1,030)

Call protection: Period during which bonds cannot be called

Call risk: Risk that bonds will be called when rates fall

Why Issuers Call: When interest rates fall, companies can call existing high-rate bonds and reissue new bonds at lower rates - saving money on interest.

Investor Impact:

- Receive call price (often a small premium over par)

- Lose future high-interest payments

- Must reinvest at lower current rates (reinvestment risk)

Puttable Bonds

Puttable bonds give the bondholder the right to sell bonds back to the issuer at a specified price before maturity.

- Investor-friendly feature

- Provides protection if rates rise

- Lower yield than comparable non-puttable bonds

Convertible Bonds

Convertible bonds can be exchanged for a specified number of common shares of the issuing company.

Conversion ratio: Number of shares received per bond

Conversion price: Par Value divided by Conversion Ratio

Parity price: Price where bond value = stock value

Example:

- Bond par value: $1,000

- Conversion ratio: 25 shares

- Conversion price: $1,000 / 25 = $40 per share

If the stock rises above $40, conversion becomes attractive.

Benefits of Convertible Bonds:

- Downside protection (bond floor)

- Upside potential (stock appreciation)

- Lower coupon rate than comparable non-convertible bonds

Credit Ratings

Credit rating agencies assess the likelihood that a bond issuer will make timely payments. The three major agencies are:

- Moody's

- Standard & Poor's (S&P)

- Fitch

Rating Scale

Highest quality: S&P/Fitch - AAA; Moody's - Aaa; Risk Level - Lowest

High quality: S&P/Fitch - AA; Moody's - Aa; Risk Level - Low

Upper medium: S&P/Fitch - A; Moody's - A; Risk Level - Low-Medium

Medium: S&P/Fitch - BBB; Moody's - Baa; Risk Level - Medium

Investment Grade: S&P/Fitch - BBB- and above; Moody's - Baa3 and above

Speculative: S&P/Fitch - BB; Moody's - Ba; Risk Level - Higher

Highly speculative: S&P/Fitch - B; Moody's - B; Risk Level - High

Near default: S&P/Fitch - CCC, CC, C; Moody's - Caa, Ca, C; Risk Level - Very High

Default: S&P/Fitch - D; Moody's - C; Risk Level - Highest

Investment Grade vs. Junk Bonds

Investment grade: Ratings - BBB-/Baa3 or higher; Characteristics - Lower yield, lower risk

Non-investment grade (junk/high-yield): Ratings - BB+/Ba1 or lower; Characteristics - Higher yield, higher risk

Important: Many institutional investors (pension funds, insurance companies) can only buy investment-grade bonds. A downgrade from BBB to BB can trigger massive selling.

Risks of Corporate Bonds

Credit/Default risk: Issuer may not pay interest or principal

Interest rate risk: Prices fall when rates rise

Call risk: Bonds called when rates fall

Liquidity risk: May be difficult to sell quickly

Reinvestment risk: Interest reinvested at lower rates

Key Takeaways

- Secured bonds are backed by collateral; debentures are unsecured

- Callable bonds benefit issuers; puttable bonds benefit investors

- Convertible bonds can be exchanged for common stock

- Investment grade = BBB-/Baa3 or higher

- Higher-rated bonds have lower yields; lower-rated bonds have higher yields

- Corporate bonds are senior to stock but carry more risk than Treasuries