Corporate bonds are bonds issued by corporations, usually in denominations of $1,000 or multiples thereof, that pays semiannual interest that is half of the stated nominal yield of par value. So a corporate bond with a stated yield of 6% would pay $30 semiannually until maturity. At maturity the final interest payment is paid along with the par value of the bond. To the corporation, the advantage of issuing bonds instead of stocks is that, unlike stocks, bonds do not represent an ownership interest in the corporation, so ownership is not diluted, and, unlike dividends, interest payments are tax deductible. The advantage of corporate bonds to bondholders is that they have priority over stockholders if the corporation declares bankruptcy or is liquidated.
When a lender lends money to the borrower, the terms of the loan are usually written in a contract, which binds both lender and borrower. In the case of bonds, the bond indenture spells out the terms of the contract. When a corporation issues bonds, it becomes the borrower and the bond buyers are the lenders. However, the lenders in this case are not banks, and, thus, do not have the expertise to deal with the details of the loan nor would it be clear what would happen if the corporation does not abide by the terms of the indenture. Who would take action? If it were incumbent upon bondholders to monitor the corporation to be sure that it is abiding by the loan agreement or if they would have to take legal action if it were otherwise, then few, if any, investors would buy bonds, for it would be too much risk and too much of a hassle to enforce the contract.
To make bonds a marketable security, a trustee is assigned to represent the interests of the bondholders. The corporate trustee is usually a bank or a trust company, and although the trustee is paid by the issuing corporation, the trustee represents the interests of the bondholders. The bond indenture is actually a contract between the corporation and the corporate trustee. Since the trustee is the other party to the contract, the trustee can take action if the corporation does not honor the terms of the indenture.
The corporate trustee is not required by necessity, but is also required by law. The Trust Indenture Act requires a corporate trustee for any bond issue that is greater than $5 million and is sold to the public in more than 1 state. The Act stipulates that there can be no conflict of interest between the trustee's interests and the bondholders, and that the indenture must provide adequate guidelines for the trustee to represent the bondholders' interests.
The corporate trustee must keep track of all bonds sold, verifying that the amount issued is not greater than what is stated in the indenture and making sure that the corporation complies with all covenants—which are the terms of the indenture—while the bond issue is outstanding. For instance, the indenture may stipulate that the corporation maintain a certain percentage of assets over liabilities, or that the corporation does not take on too much debt. This is something the trustee would have to monitor.
Indentures usually stipulate that the trustee needs to do nothing more than what is specifically stated in the indenture—there are no implied covenants or duties. The trustee does not have to exercise its duties at the request of bondholders, although the trustee can if it chooses.
The bond indenture must resolve conflicting objectives between what the issuer wants and what the bond buyers want. Issuers want to pay the least amount of interest with the least restrictions in their freedoms, while bond buyers would want the highest interest, with those restrictions that would prevent the issuer from doing anything that would lower the credit rating of the issuer, which would increase the risk of default and lower the prices of the bonds in the secondary market. The bond issuer willingly adds restrictions, however, since the bonds would sell for a lower yield than without them.
Corporate Bond Types
Corporate bonds can generally be classified by the type of issuer. The following list is only indicative of the many corporate bond types:
- public utilities
- communication companies
- electric companies
- gas companies
- water companies
- transportation companies
- trucking companies
- industrial companies
- manufacturing companies
- mining companies
- service-related companies
- banks and finance companies
- international bonds (aka Yankee bonds)
Corporate bonds can be straight-coupon bonds (aka fixed-rate bonds), zero-coupon bonds, and floating-rate bonds. Straight-coupon bonds pay a fixed rate of interest on the par value of the bond. Zero-coupon bonds pay no interest until maturity, and floating-rate bonds pay a variable interest rate that is set at specified intervals at a spread from a specified index or security, such as a Treasury of the same maturity.
The interest on straight-coupon and floating-rate bonds is paid semiannually with the final interest payment added to the par value of the bond at maturity. The interest rate is calculated using a banker's year of 360 days that is divided into 12 30-day months.
While most fixed-rate bonds have similar characteristics in regards to interest payments, there are some fixed-rate bonds that have special features or that differ significantly from the rest. Most of these special issues are from less creditworthy corporations, and the features were added to make the bonds more marketable.
Participating bonds share in the profits of the issuer or in the increase of some stipulated assets above a minimum, allowing the bondholder to earn more than just the interest.
Income bonds, which are usually issued by financially distressed companies emerging from bankruptcy or a reorganization, pay a stipulated interest rate only if there is enough income, as defined in the indenture, to pay interest. If there is insufficient income, then the interest payment is skipped. If the interest is cumulative, then the bond issuer is obligated to pay the bondholders all interest payments before maturity. If the interest is noncumulative, then any missed interest payments are forfeited by the bondholders. Since the possibility of missed payments is stipulated in the indenture, the missed payments do not constitute default. Instead, the bondholders accept a higher yield in exchange for the greater risk and for the greater uncertainty of the payments.
Zero Coupon Bonds
Zero-coupon bonds pay no interest. The interest earned is the difference between the discounted price and the par value of the bond, which is paid at maturity. The difference between the par value and the issuing price is the original-issue discount (OID). The interest rate of a zero-coupon bond is proportional to the amount of the discount and inversely proportional to the term of the bond. The actual rate will depend on how it is calculated: whether as simple or compounded interest, and the length of the compounding period.
Most currently issued zeros are convertible, callable, and putable. These features allow the issuer to sell the bonds for a lower yield. Merrill Lynch pioneered this type of product by introducing Liquid Yield Option Notes (LYONs). Convertible bonds usually are convertible into company stock at a stipulated conversion price. Hence, the greater the stock price, the more valuable the conversion feature. Putable bonds can be sold back to the issuer for the stipulated put price, which, in most cases, is the par value. Callable bonds can be called by the issuer for the call price. In most cases, the call price is initially higher than the par value, but declines to the par value after a specified number of years. There is usually a specified date before any of these features take effect.
Corporate zeros were 1st issued in 1981. Initially, taxes didn't have to be paid on the accruing interest until it was actually received at maturity, or sold, but the IRS changed the rules and required that taxes be paid when they were earned. Afterwards, they become less popular. (More info: Taxation of OID Interest)
However, zeros have 2 major advantages: the ability to more precisely match income with liabilities and greater potential profits. Many organizations, especially insurance companies and pension funds, use zeros to match their income to their liabilities, since, in these cases, income is being received now that will incur a liability well into the future.
Zeros can also earn superior returns in a falling interest environment. Although the amount of interest is determined by the purchase price, the prices of zeros are much more volatile in the secondary market—the longer the time until maturity, the greater the volatility. This results from the fact that a zero has only a single payment, and, hence, the present value of that payment, and therefore the price of the bond, depends strongly on current interest rates. If interest rates are currently high, then zeros are especially attractive, because there is less reinvestment risk since interest rates are more likely to go lower. Falling interest rates would also cause the price of a zero in the secondary market to increase faster than a coupon bond. However, the opposite is true if interest rates are already low by historical standards. If interest rates increase, then there is no coupon payment to be reinvested at higher interest rates, and the price of the zero will fall faster.
There are some credit risks that are higher for zeros than for coupon bonds. Because the corporation makes a single payment for a zero, it could have a very large liability at maturity, which it may be unable to pay, especially since, in most cases, there is no sinking fund or other means of reducing the debt before the final payment. This is why most zeros are callable, since it allows the issuer to call the bonds over time and avoid a single large payment.
If the corporation declares bankruptcy before the maturity date of the zero, then the bondholder will only be entitled to the original issue discount plus any accrued interest—not the face value of the bond.
Trade Reporting and Compliance Engine (TRACE)
TRACE is a FINRA approved trade reporting system for corporate bonds trading in the OTC market. TRACE only reports trades: it does not provide execution, settlement, or clearance services. Trades must be reported by both sides of the transaction within 15 minutes of execution, and the report must include execution date, time of trade, quantity, price, yield, and if the price reflects a commission. Most corporate debt securities are eligible for the system, but not the following:
- mortgage and asset-backed securities, including collateralized mortgage securities
- money market instruments
- municipal securities
- foreign country and foreign government-sponsored debt
- convertible corporate bonds
Priority of Creditors in a Corporate Bankruptcy
Bonds are usually a safe investment, but when a company goes bankrupt, the claims of creditors have the following priorities, from highest to lowest: