Cash Equivalents and Fixed Income Securities - Corporate Bonds

Corporations issue bonds when they want to raise capital.

Corporate Issuer Requirements

  • New issues must be registered as a security under the Securities Act of 1933 and are subject to the Trust Indenture Act of 1939.
  • Each bond must have an indenture which spells out provisions such as term, interest rate, call provisions, etc.
  • Furthermore, a trustee is named to act on behalf of the bondholders to make sure the company honors this agreement.

The Four Types of Corporate Bonds

  • Secured bonds
    • Backed by specific collateral and therefore considered lower risk than unsecured bonds with comparable qualities

    • Examples include mortgage bonds (senior or junior), equipment trust certificates and collateral trust certificates

  • Unsecured Bonds
    • Backed only by the company's commitment to pay

    • Examples include commercial paper, debentures, subordinated debentures and income bonds (also known as adjustment bonds).

  • Convertible Bonds
    • Debentures that can be converted to shares of the issuer's common stock at the option of the owner

    • The conversion price is set at the time of issuance, usually at a price higher than the current market price.

    • The bondholder is not likely to convert to the common stock unless the market price of the stock rises above the exercise price, also known as the conversion price.

    • For example, the stock of Doggie Snacks Inc. trades at $18 a share when the company issues a $1,000 convertible bond with a conversion price of $25 a share. That would mean an investor could exchange that $1,000 bond and convert it into 40 shares of the company's stock.

    • The conversion ratio represents the number of shares the investor will receive for converting the bond into stock. In the example above, the conversion ratio is 40.

    • Conversion ratio = Par Value of Convertible Bond / Conversion Price

  • Zero-coupon Bonds
    • Bonds that sell at a discount to par; there are no interest payments paid to the investor. The "interest rate" is received when the bond matures at par.

    • Since the imputed interest is taxable to the investor each year, these are most attractive in tax-deferred retirement accounts.

    • Zero-coupon bonds are the most volatile type of fixed-income securities because of the lack of interest payments. When interest rates rise, zero-coupon bonds fall more dramatically than bonds making coupon payments; but they also rise more dramatically when interest rates fall.

    • Example: A one-year, zero-coupon with a par value of $1,000 might sell for $950. At maturity, the investor receives $1,000. The $50 received over the original investment represents the investor's return. In this case, the investor's return was 5%.

Look Out!
It is important to recognize secured bond types versus unsecured bonds, since 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).

Exam Tips and Tricks
On the subject of bonds, you might encounter a question like this on the exam:

Which of the following would be the LEAST important in evaluating the diversification of a bond portfolio?

  1. The maturities of the bonds
  2. The states where the bond issuers are located
  3. The credit ratings of the bonds
  4. Type of bonds (secured or unsecured)

The correct answer is "b" - the location of the issuing company is the least important factor. Credit rating and maturities are of the highest importance, but it's also important that the portfolio contain some secured bonds to reduce risk.

U.S. Government Securities
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