Characteristics, Uses and Taxation of Investments - Corporate Bond



d.
Corporate Bonds: these are obligations issued by either public companies or those being taken private through leverage, though the latter category may be often be subsumed under high yield bonds.

    1. Mortgage Bond - a form of secured bond with the highest priority among all claims on assets pledged as collateral.
      1. Open-End Indentures - the corporation may issue more bonds of the same class at a later date which are secured by the same collateral backing the original issue with equal liens on the property.
      2. Closed-End Indentures - the corporation is not permitted to issue more bonds of the same class in the future. Subsequent issues have a subordinated claim on the collateral.
      3. Prior Lien Bonds - the corporation would issue a bond taking precedence over first-mortgage bonds only with the first mortgage bondholders' consent which is unlikely.
    2. Debenture - these are obligations issued by corporations backed only by the creditworthiness of the company. Accordingly, their yield is higher than corporate bonds with similar terms backed by hard assets. These, in turn, may fall within either the investment grade or high yield categories.
    3. Investment Grade - these are corporate obligations with a credit rating of BBB/Baa from the two major credit rating agencies, Standard & Poor's and Moody's, respectively. Bonds with this level of creditworthiness are that much more likely to be able to pay interest and repay principal. Price appreciation is subject to short or long term capital gains tax, while coupon income is taxed as ordinary income at the taxpayer's marginal tax rate. These bonds' creditworthiness affords them greater liquidity.
    4. High-Yield - refers to that segment of the bond market that enables non-investment grade companies to obtain capital.[Credit ratings below BB-B/Ba-B from Standard & Poors and Moody's respectively are non-investment grade.] Once considered an outcast of the fixed income arena, high yield debt is today a relatively stable market with improved overall credit quality, less of a financing tool for buyouts and acquisitions and more of one for growth capital. Because of their higher risk profile, some analysts are inclined to view them almost as equities in bond clothing. Additionally, the below-investment grade rating causes such bonds often to be excluded from qualified retirement plans. Most are plan vanilla fixed-rate, cash-pay structures, but some alternatives exist with features such as deferred payments (income bonds which trade flat, e.g. without interest), step-up payments, extendible maturity/coupon reset or payment-in-kind arrangements (where the option exists to pay interest or like-kind securities). The more creative offerings exist to accommodate cash poor higher risk companies in certain industries such as cable, media and telecommunications. About three quarters of outstanding high yield debt is callable. Coupon income is taxable as ordinary income and gains on the sale of a bond are taxed at prevailing capital gains tax rates. Because many of the research tools needed to perform the requisite credit analysis on such bonds are beyond the grasp of and availability to most individual investors, professionally managed funds may often be a more prudent approach.
    5. Convertible - nominally fixed income, these are more of a hybrid security, conferring upon the holder the right to convert the bond into a specified quantity of shares of the issuer[One should note the term exchangeable bond which enables the bondholder to exchange the issue for a specified number of shares of common stock of a corporation different from the issuer of the bond. (Fabozzi, Frank J. PhD, CFA FIXED INCOME ANALYSIS for the Chartered Financial Analyst ® Program Second Edition, 2004)]. Therefore, it is a bond with an embedded option granted to the investor (bondholder). Valuation is more complex for two reasons. Since such bonds may be callable or putable [A LYON (Liquid Yield Option Note) contains both call and put features. A zero coupon convertible bond, a [A LYON (Liquid Yield Option Note) contains both call and put features. A zero coupon convertible bond, a [A LYON (Liquid Yield Option Note) contains both call and put features. A zero coupon convertible bond, a [A LYON (Liquid Yield Option Note) contains both call and put features. A zero coupon convertible bond, a LYON may be called by the issuer or put back to the issuer by the holder.], their value depends on how interest rates change, affecting the value of any call or put feature. Additionally, changes in the market price of the issuer's underlying stock affect the value of the conversion option. The presence of this feature is advantageous to the issuing company as it may offer a lower yield in exchange for giving the bondholders the opportunity to convert. Such a feature is less favorable to the bondholder who accepts a lower yield for the possibility of converting the bond into stock. That possibility may not materialize [Busted convertible or fixed income equivalent are terms used interchangeably to describe a bond with no possibility of conversion due to too low a share price of the issuer.]. Beneficial to the bondholder is the ability to convert the bond into shares if worthwhile, yet have the downside protection and income stream of a fixed income instrument. Convertibles offer equity participation with seniority in a company's capital structure as they are bonds. Convertible bonds exhibit a higher correlation with equity securities due to the conversion option and may afford the investor the opportunity to diversify. Note formulas including break-even time.
Convertible Bond Mathematics


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