Corporate Bond Types
In almost all cases, the interest rate of a loan is lower if the loan is secured by collateral. Since corporations want to pay the lowest interest rate on their bonds, they frequently secure the bond payments with collateral. The terms of the bond are stated in the indenture. Corporate bonds can be classified according to the type of collateral that they provide. Many of these bonds are also insured to lower the interest rate even more.
A mortgage bond provides bondholders with a 1st lien on corporate property. A lien, in this case, gives the bondholders the right to sell the property if the corporation defaults on its payments. Even if a corporation does default, the corporate trustee, who represents the interests of bondholders, rarely has to seize property and sell it for the benefit of bondholders. Most often, the company reorganizes and arranges other means of paying the bondholders, since the lien gives it a strong incentive to satisfy the claims of the bondholders.
Corporations may also offer different classes of mortgage bonds, based on the seniority of claims on the collateral. First-mortgage bonds have 1st claim on the pledged property, second-mortgage bonds have 2nd claim, etc.
Mortgage bonds are often issued as a means of continuous financing and expansion because it is cheaper than issuing new stock, and ownership interest is not diluted. To reduce costs and time to issuance, mortgage bonds are usually issued as a series of bonds having the same indenture and the same claim to property. As each issue matures, another issue based on the same mortgage — called a blanket mortgage — is issued. If property is sold or released from the mortgage, either other property is substituted or some bonds are retired to maintain the adequacy of the collateral.
There are some common indenture provisions designed to protect the bondholders even more. The after-acquired clause stipulates that property acquired after the 1st lien will also be subject to the lien. Additional issues cannot be more than 60% of the secured property value acquired after the 1st lien.
Another common clause is that earnings of the period preceding a new issue must exceed some specified multiple of the annual interest paid on all bonds.
The indentures of most mortgage bonds allow additional bonds to be issued to replace retired bonds. Open-end indentures permit the corporate issuer to issue more bonds of the same class later, secured by the same collateral and having equal liens on the property. Closed-end indentures do not allow the issuance of any more bonds of the same class. All future issuances will have a subordinated claim on the collateral.
Prior lien bonds are usually issued by companies in financial trouble, and they can even take precedence over 1st mortgage bonds, but a corporation must get the consent of 1st mortgage bondholders, who, for obvious reasons, usually don't approve.
Some bonds backed by 2nd or 3rd mortgages are indicated by a variety of names: first and consolidated, first and refunding, and general and refunding mortgage bonds. Although some of these bonds have a 1st lien on property, much of the collateral is subordinated to bonds based wholly on 1st liens. Consequently, these bonds generally pay a higher yield and have a greater credit risk.
Collateral Trust Bonds
Collateral trust bonds are secured by other securities, such as stocks and bonds. These are often issued by companies that own little or no real estate, but own a significant amount of securities. Holding companies, for instance, are companies that control other companies, which are subsidiaries, and they have this control because of the stock they own in each of the subsidiaries.
Usually, most bond indentures stipulate that the market value of the securities must exceed the amount of the outstanding bonds by a certain percentage. If the market value falls below this minimum, then the issuer must provide more collateral. A common indenture provision allows the issuer to substitute other securities for those pledged.
The securities are delivered to the corporate trustee to hold for the benefit of the bondholders. However, the issuer maintains voting rights granted by owning the securities. If the issuer defaults, however, then the voting rights are transferred to the trustee. The trustee may sell the securities to pay the bondholders. Or the trustee may wait until the company reorganizes if the trustee thinks it would benefit the bondholders.
Like mortgage bonds, collateral trust bonds may be issued in series, where each series is based on the same collateral and the same bond indenture. However, how the new bond proceeds may be used is commonly restricted to protect the interests of prior bondholders.
Equipment Trust Certificates (ETCs)
Equipment trust certificates were pioneered by railroad companies and are still the main issuers, although some airlines also issue this type of bond. These bonds are considered the safest of corporate bonds because of the way that the bonds are secured.
The corporate trustee of the bond issue has legal title to the equipment that is financed by the certificates. The railroad leases the equipment from the trustee, with the amount being at least enough to pay interest and to retire the certificates periodically. The trustee sells the equipment trust certificates for about 80% of the value of the equipment, then pays the manufacturer of the equipment with the proceeds. The rest is paid by the railroad as an initial payment of rent.
The security of equipment trust certificates is based on the fact that the trustee has legal title to the equipment. If the company defaults, the trustee will have no problem leasing the equipment to another company, because the rolling stock of railroads is fairly standardized, and has a ready market. Furthermore, the equipment is easily transferable. This arrangement is set up willingly by the railroads so that they can pay the lowest yield, since the railroads have to borrow a lot of money to finance their equipment purchases.
The trustee collects the rent payment from the railroad to pay interest and principal to the bondholders. Historically, these interest payments were called dividends.
ETCs are usually issued as a series, with an equal number of bonds paid off each year, which spreads the payments over the term of the series. Thus, for a 15-year, 75 million dollar issue, $5,000,000 of the certificate would be retired each year until the entire issue is retired. The yields on the certificates are determined by the yield curve when issued. Generally, certificates with longer maturities pay higher yields.
At maturity of the issue, the lease is terminated. The railroad pays the trustee a nominal price for the equipment, which it then owns outright.
Even though the trustee has legal title to the equipment, the certificates are legal obligations of the company leasing the equipment and are listed as liabilities on its balance statement.
Debentures issued in the United States, which constitute most of the corporate bonds issued, are bonds with no pledged collateral. However, the holders of debentures do have a claim over all the property of the issuer as a general creditor. By contrast, debentures issued in the United Kingdom are collateralized.
Most debentures are issued by creditworthy corporations that can sell their bonds for a low yield without pledging collateral. However, some debentures are issued by companies who already issued mortgage bonds or already pledged much of their property for loans. These debentures are subordinated to the secured credit.
To make their bonds more saleable, less creditworthy corporations include a number of provisions in the indenture to protect the holders of the debentures. For instance, the issuer may be required to maintain a net working capital that is at least as great as the amount of debentures outstanding. Or the issuer may not be able to pay more than a certain percentage of its current earnings in the form of stock dividends. If the company has no pledged property, then it may guarantee that the owners of the debentures will have a security interest in the company's property that is at least as great as any secured creditors in the future.
Subordinated debentures are debentures with an inferior claim on the earnings and assets of the issuer compared to other debt holders. Subordinated debentures are often issued by companies that have already borrowed a lot of money, and need to borrow more. Hence, subordinated debentures have a high credit and default risk, and the yields that the issuer must pay on these bonds are higher. Similarly, junior subordinated indentures have an even lower credit standing and must pay higher yields. However, even the claims of junior subordinated debenture holders are superior to the claims of common and preferred stockholders in the event of a liquidation.
Sometimes the issuer will add features to the bond to lower the interest rate that it must pay. One common feature is the ability to convert the bond into so many shares of company stock. The holders of these convertible bonds have a chance to make a lot more money if the company does well, and so are willing to accept a lower interest rate. A variation of the convertible bond is the exchangeable bond, which allows the bondholder to convert the bond into a specified number of shares of an affiliate or a subsidiary of the issuer.
Convertible bonds and convertible preferred stock allow the holders of these securities to convert the security into the common stock of the issuing company. Because the convertibility has value, the issuer receives a higher price for its bonds, allowing it to pay lower yields. Convertible securities are characterized by either specifying the conversion ratio explicitly or by specifying the conversion price in the bond indenture. The conversion ratio is the number of shares of stock that can be converted for each convertible security. As another way to calculate the conversion ratio, the conversion price is the specified stock price used in determining the conversion ratio.
Example: How the Conversion Ratio Determines the Conversion Price
- A convertible bond with a face value of $1,000, and a conversion ratio of 10, would be convertible into 10 shares of stock.
- Alternately, if the bond indenture specified a conversion price of $50 per share, then the bond could be converted into 20 shares of stock.
The conversion price is specified before the convertible security is issued, and is always higher than the market value of the stock on the date of issue; otherwise, bond buyers would immediately convert their bonds into stock, thereby defeating the purpose of issuing the security in the 1st place. The current stock price determines whether the convertible security will be converted or not. Most convertibles are issued deep out of the money, so the stock would have to appreciate considerably before it would be profitable to convert. The conversion value is the value received if the convertible was converted into stock.
The convertible bond is more valuable than a straight bond, because the convertible can be considered to consist of 2 securities — the straight bond and a call option to buy company stock for the conversion price. If the stock price is below the conversion price, then the option only has time value, making the convertible bond only a little more valuable than the straight bond. As the stock price increases, the call option becomes more valuable. As the stock price increases above the conversion price, the bond price moves proportionately higher. The convertible bond value is always a little greater than the conversion value, because the bond provides some protection against a stock price decline. If the stock declines below the conversion value, then the bond still has worth as a straight bond. Thus, a convertible bond is like owning the stock with a protective put that has a strike price of the straight bond. Note, also, that a stock price above the conversion price will be a major determinant of the bond's price, and will lower the yield-to-maturity rate on the bond as the bond's value increases with the stock price.
However, the value of the call feature of convertibles is difficult to calculate because the stock may have paid dividends during the life of the convertible, the conversion price might rise at specified times, and most convertibles are callable. A forced conversion occurs when the company issues a call on the convertible when the conversion price is less than the stock price. The bondholders have about a month to convert, so if the current stock price is higher than the conversion price, the bondholder will convert the bond to stock for an immediate profit rather than having it called away at a lesser price.
Convertible bonds are covered by an antidilution covenant in the trust indenture, requiring adjustments to the conversion price for stock splits and dividends, and the issuance of new shares.
Example: How the Conversion Price Is Affected by Stock Dividends
- Conversion price: $25
- Number of shares: 40 shares
Issuer declares a stock dividend of 25%, so the convertible bondholder's 40 shares are adjusted to 50 shares ( = 40 × 1.25), and the conversion price is adjusted to $20 ( = 25 ÷ 1.25).
Reverse convertible bonds have an embedded put option that allows the bond issuer the right, but not the obligation, to convert the bond's principal into shares of equity at a predetermined price and date. The issuer would exercise the option if the underlying shares fell below the set price, in which case, the bondholders would receive the shares instead of the principal when the bond matured. Because bondholders assume additional risk, reverse convertibles generally have a higher yield.
The difference between convertibles and reverse convertibles is that with convertibles, it is the bondholder that has the option of converting the bond, whereas with reverse convertibles, it is the issuer that has the option. By exercising the option to convert, the convertible bondholder profits, but, with reverse convertibles, the issuer profits from the conversion.
Guaranteed bonds are bonds whose interest payments and/or principal repayment are guaranteed by a corporation who is not the issuer. Most guaranteed bonds are issued by railroad companies, and many guarantors are corporate parents of the issuing subsidiary. While guaranteed bonds are debentures, the credit quality of the bonds is generally higher since both companies are obligated to make good on the bonds in the event of a default.