Investment Securities - Corporate Bonds
Definition and Features
Debt securities refer to bonds, as well as shorter term instruments such as notes and bills. Unless otherwise noted, references to debt securities in the study guide and the exam refer to bonds. Before we delve into basic bond concepts, our Bond Basics tutorial will be helpful as a quick preview and primer.
When a corporation needs to raise additional capital to fund its operations, it can use two types of financing: equity financing and debt financing. An equity, or stock, is an ownership stake held by a shareholder in a corporation. A bond, on the other hand, is a debt security issued by the corporation. The bond's indenture contractually stipulates that the investor will be repaid his or her invested principal plus interest. In other words, the investor is loaning money to a corporation. While corporate bonds have a predictable cash flow and are a more stable investment than stocks, they do not have the long-term capital growth potential of stocks. This is one of the trade-offs that you will need to explain when you speak with your customers about their investment goals, financial needs and risk tolerance.
What are Corporate Bonds?
A corporate bond is a contract between a corporation and the investor, whereby the investor lends the corporation money, in return for a legal promise that the corporation will pay the principal back to the investor on a specified date, with interest. The terms of the legal agreement between the investor and the corporation are spelled out in the bond's indenture (also called the "deed of trust") on the bond certificate. It will specify how and when the principal will be repaid, the rate of interest (also called the coupon), a description of property secured as collateral against default, and steps that shall be taken in the event of default.
Like any other debt, corporate debt can be either secured or unsecured:
Secured Debt: Secured bonds are backed by assets owned by the issuing corporation. If the issuer of the secured debt, (the corporation) goes bankrupt, the trustee will take possession of the assets and liquidate them on the bondholders' behalf. If the company defaults the bondholders will be repaid from the proceeds from the sale of the company's assets, which secure the payments.
There are several types of secured corporate bonds:
- Mortgage bonds are secured by a first or second mortgage on real property.
- Equipment trust certificates are secured by a specific piece of equipment. For example an Airplane, or Railroad cars
- Collateral trust bonds are secured by the securities of another corporation, which is usually affiliated with the issuer in some way.
- There are several types of secured corporate bonds:
Unsecured Debt: Unsecured bonds, also known as debentures, are secured only by the corporation's good faith and credit, and not by a specific asset. If the company defaults, the bondholders will have the same claim on the company's assets as any other general creditor. Though secured bondholders will be paid before debenture holders, owners of stock will be paid after unsecured bondholders.
A call feature is a stipulation in the indenture of a bond that allows the issuer to redeem the bond, either in whole or in part, before the maturity date. The issuer notifies the bondholder that it will redeem the bond at a particular price on a given day. In return, the issuer will usually pay a call premium to the bondholder. This usually occurs in declining interest rate environments, when an issuer can replace a series of bonds with another debt issue for which it can pay a lower coupon rate and thus save money.
Exam Tips and Tricks
It is important to be able to distinguish secured bond types from unsecured bonds because exam questions may present you with four potential scenarios of how liabilities are to be paid upon corporate liquidation. In such a situation, mortgage bonds have priority over debentures, followed by preferred stock and then common stock.
- High-Yield (Junk) Bonds: Unsecured corporate bonds that are not considered investment grade by credit rating companies - those rated BBB or below by Standard & Poor's (S&P) or Baa or below by Moody's, for example - are called high-yield bonds, or junk bonds. The financial profile of a company issuing high-yield bonds will raise questions among bond analysts about the company's ability to return principal and make timely interest payments to bondholders. To justify the higher degree of risk that an investor must assume when lending money to such a corporation, junk bonds must pay higher yields to investors than bonds with investment-grade credit ratings
- Convertible Bonds: A corporation may issue convertible bonds, which allow investors to convert a bond into shares of the company's common stock at a predetermined ratio. A corporation will issue these bonds to borrow money at a lower rate of interest than the company would pay on an equivalent non-convertible bond issue. The assumption is that investors will forgo a bit of interest on exchange for the conversion feature.
Whether or not it is worthwhile for the investor to convert the bond to the underlying stock will depend largely on the price of the stock. The convertible bond indenture may state the number of shares into which the bond may be converted, or it may give the conversion price.
- Conversion price is the price per share at which the corporation will sell the bondholder the stock in exchange for the bond.
- The conversion ratio is the par value of the bond divided by the conversion price, and it gives you the number of shares received for each bond.
- When the market price of the stock equals the conversion price of the stock, the situation is called parity.
Exam Tips and Tricks
You may be asked to calculate three things on the exam: the conversion price, the conversion ratio, or the parity price of the stock.
First, remember that the underlying bond has a par value of $1,000. Finding the conversion price or conversion ratio is simple:
Cconversion ratio = Par value / Conversion price