Complete Guide To Corporate Finance


Bonds - Types Of Bonds

This section describes the various types of bonds that a company might issue. (To learn about government-issued bonds, read Basics Of Federal Bond Issues, Savings Bonds For Income And Safety and 20 Investments: Municipal Bonds.)

Corporate Bonds
A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-term corporate bond has a maturity of less than five years, intermediate is five to 12 years and long term is more than 12 years.

Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed-income investments because of the risk the investor must take on. The company's credit quality is very important: the higher the quality, the lower the interest rate the investor receives.

Variations on corporate bonds include convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity.

Convertible Bonds
A convertible bond may be redeemed for a predetermined amount of the company's equity at certain times during its life, usually at the discretion of the bondholder. Convertibles are sometimes called "CVs."

Issuing convertible bonds is one way for a company to minimize negative investor interpretation of its corporate actions. For example, if an already public company chooses to issue stock, the market usually interprets this as a sign that the company's share price is somewhat overvalued. To avoid this negative impression, the company may choose to issue convertible bonds, which bondholders will likely convert to equity should the company continue to do well.

From the investor's perspective, a convertible bond has a value-added component built into it: it is essentially a bond with a stock option hidden inside. Thus, it tends to offer a lower rate of return in exchange for the value of the option to trade the bond into stock.

Callable Bonds
Callable bonds, also known as "redeemable bonds," can be redeemed by the issuer prior to maturity. Usually a premium is paid to the bond owner when the bond is called.

The main cause of a call is a decline in interest rates. If interest rates have declined since a company first issued the bonds, it will likely want to refinance this debt at a lower rate. In this case, the company will call its current bonds and reissue new, lower-interest bonds to save money.

Term Bonds
Term bonds are bonds from the same issue that share the same maturity dates. Term bonds that have a call feature can be redeemed at an earlier date than the other issued bonds. A call feature, or call provision, is an agreement that bond issuers make with buyers. This agreement is called an "indenture," which is the schedule and the price of redemptions, plus the maturity dates.

Some corporate and municipal bonds are examples of term bonds that have 10-year call features. This means the issuer of the bond can redeem it at a predetermined price at specific times before the bond matures.

A term bond is the opposite of a serial bond, which has various maturity schedules at regular intervals until the issue is retired.

Amortized Bonds
An amortized bond is a
financial certificate that has been reduced in value for records on accounting statements. An amortized bond is treated as an asset, with the discount amount being amortized to interest expense over the life of the bond. If a bond is issued at a discount - that is, offered for sale below its par (face value) - the discount must either be treated as an expense or amortized as an asset.

As we discussed in Section 4, amortization is an accounting method that gradually and systematically reduces the cost value of a limited life, intangible asset. Treating a bond as an amortized asset is an accounting method in the handling of bonds. Amortizing allows bond issuers to treat the bond discount as an asset until the bond's maturity. (To learn more about bond premium amortization, read Premium Bonds: Problems And Opportunities.)

Adjustment Bonds
Issued by a corporation during a restructuring phase, an adjustment bond is given to the bondholders of an outstanding bond issue prior to the restructuring. The debt obligation is consolidated and transferred from the outstanding bond issue to the adjustment bond. This process is effectively a recapitalization of the company's outstanding debt obligations, which is accomplished by adjusting the terms (such as interest rates and lengths to maturity) to increase the likelihood that the company will be able to meet its obligations.

If a company is near bankruptcy and requires protection from creditors (Chapter 11), it is likely unable to make payments on its debt obligations. If this is the case, the company will be liquidated, and the company's value will be spread among its creditors. However, creditors will generally only receive a fraction of their original loans to the company. Creditors and the company will work together to recapitalize debt obligations so that the company is able to meet its obligations and continue operations, thus increasing the value that creditors will receive.

Junk Bonds
A junk bond, also known as a "high-yield bond" or "speculative bond," is a bond rated "BB" or lower because of its high default risk. Junk bonds typically offer interest rates three to four percentage points higher than safer government issues.

Angel Bonds
Angel bonds are investment-grade bonds that pay a lower interest rate because of the issuing company's high credit rating. Angel bonds are the opposite of fallen angels, which are bonds that have been given a "junk" rating and are therefore much more risky.

An investment-grade bond is rated at minimum "BBB" by S&P and Fitch, and "Baa" by Moody's. If the company's ability to pay back the bond's principal is reduced, the bond rating may fall below investment-grade minimums and become a fallen angel.

For more about bonds, see our Bond Basics Tutorial and Advanced Bond Concepts Tutorial.

Bond Valuation
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