If a corporation wants to raise money, it could issue new stock, issue preferred stock, or issue bonds. New stock dilutes ownership of the company, and gives voting rights to its holders. Preferred stock confers no voting rights, except in certain cases when the stock dividend is not paid, and, although it usually pays a dividend, the dividend does not have to be paid if the company is in financial trouble. However, the dividend is not tax deductible. The advantage of issuing bonds is that ownership is not diluted, no voting rights are conferred, and the interest paid is tax deductible. The big disadvantage of bonds from the corporate viewpoint is that the interest must be paid, or it will be held in default, and sued by the bond's trustee.
Many companies establish a sinking fund, which is a special custodial bank account where money is transferred from the company regularly to pay off some of its outstanding bonds. A sinking fund bond is generally considered to be safer because the company redeems the bonds periodically instead of all at once.
Corporate bonds are categorized as investment grade or high-yield bonds. Investment grade bonds have a credit rating in the highest 4 categories of credit risk, with very low risk of default. When the investor, such as a pension fund, has a fiduciary duty to others, it is generally restricted to investing in investment grade bonds.
High-yield bonds have a credit rating below the top 4, and are often referred to as junk bonds, because of their higher risk of default. Because of the greater risk, they pay a higher interest rate�the lower the credit rating, the higher the interest rate that must be paid by the company to sell its bonds. Investors can not only earn higher interest with high-yield bonds, but may also be able to benefit from improvements in price of the bond in the secondary market, if the credit rating of the company increases.
Sometimes the corporation suffers financially enough that it stops paying interest on its bonds. Such bonds are said to be trading flat, and their prices drop significantly. Some investors buy these bonds for much less than their face value in the hope that the corporation will improve financially and begin paying interest, including any arrears, which is the total interest that was due, but not paid. If the principal is ultimately paid, then this further increases the yield to maturity of the bond. However, if the financial health of the company does not improve, then the entire investment could be lost.
Bonds can be classified as either secured or unsecured. Secured bonds, or asset-backed bonds, are backed by assets of the corporation, such as real estate or equipment. The safety of unsecured bonds, called debentures, depends on the faith and credit of the issuer.
Most corporate bonds correspond to 3 major market sectors:
Mortgage bonds are secured by real estate.
The equipment trust certificate is a bond secured by equipment, frequently issued by railroads and other transportation companies. A down payment is made on the equipment by the corporation, which then issues equipment trust certificates to finance the rest. The certificate holder receives both principal and interest every year until maturity. Often these bonds are issued as serial bonds, which are bonds of the same type, but mature at regular intervals as the collateral depreciates.
Collateral trust certificates are secured by other securities that the corporation owns, which may be the corporation's own securities, or of other companies. These securities are deposited into a trust for the benefit of the bondholders. The safety of these bonds is related to the safety of the underlying securities.
A debenture is a bond that is not secured by any property. Its safety depends on the assets and earning power of the issuer. Thus, debentures are not as safe as other bonds from the same company.
These bonds are insured by another company, or the parent company. Although these bonds are not risk-free, default risk is reduced since both companies would have to default.
Not a good investment for regular income, these bonds pay interest if earned, and only to the extent of earnings, up to a maximum. These bonds are usually issued by bankrupt companies reorganizing. These are the only bonds where nonpayment of interest does not lead to an immediate default.
Corporate Bonds
Bond Yields, Credit Risk, Taxable Equivalent Yield (TEY)
Special Bonds - Advanced Refunded Bonds, Put Bonds, Convertible Bonds
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