Corporations borrow large amounts of money for many reasons. Here are some real-world examples:
When corporations need money, they typically raise capital in one of two ways: equity or debt.
When a corporation borrows by issuing bonds, there are clear trade-offs.
For example, in the Amazon offering cited above, part of the deal included a 3-year, $1 billion note with a 0.4% interest rate. That’s extremely low for corporate borrowing, but the interest cost is still meaningful:
In this chapter, you’ll learn about several different types of corporate debt, including:
As you can see, corporations can issue many types of debt securities to raise capital. Each type has its own benefits and risks, and we’ll work through them throughout this chapter.
We originally discussed liquidation priority in the common stock chapter, but it’s worth revisiting here. If a company is forced to liquidate its assets, it pays out the liquidation proceeds in this order:
Unpaid wages
Unpaid taxes
Secured creditors
Unsecured creditors
Junior unsecured creditors
Preferred stockholders
Common stockholders
A bondholder is a type of creditor. After unpaid wages and taxes, the next group is secured creditors, which is where collateralized bonds fall. These bonds are backed by a specific asset that can be sold if the issuer fails to make interest or principal payments.
There can be some confusion about the order of unpaid wages and taxes versus secured creditors, depending on the source. Secured creditors have first rights to the collateral backing the loan. If the collateral is liquidated and doesn’t fully cover the loan balance, the liquidation priority above applies to the remaining assets.
To demonstrate this, assume a secured creditor is owed $1,000, and $100 of wages and $100 of taxes are outstanding. If the collateral backing the secured loan is liquidated for a total of $600, all goes to pay back the secured creditor, bringing their loan balance down to $400. Now, the rest of the company’s assets are liquidated for a total of $500. $100 goes to unpaid wages, $100 goes to unpaid taxes, and the remaining $300 goes to the secured creditor. This leaves the secured creditor with $100 unpaid.
The order of unpaid wages and taxes versus secured creditors is not heavily tested. Exam questions more commonly focus on the priority of creditors (bondholders) versus equity holders (stockholders).
Unsecured creditors come next. This is where unsecured bonds, also called full faith and credit bonds, fall. If a bond has no collateral backing it, it’s unsecured. Because unsecured creditors are lower in priority than secured creditors, unsecured bonds are generally riskier than secured (collateralized) bonds.
After unsecured creditors, we have junior unsecured creditors, also called subordinated debenture holders. These are similar to regular debentures, except they rank lower in liquidation priority. For legal reasons you don’t need to focus on here, issuers are sometimes required to issue subordinated (junior) bonds. Because they have no collateral and rank lower in priority, they carry more risk than regular debentures.
After the creditors, we have stockholders. Preferred stockholders come first, and common stockholders come last. Stockholders are owners of the company, so they’re paid only after creditors have been paid. In many liquidations, there is little to no money left for stockholders.
Commercial paper, sometimes described as a type of promissory note, is a short-term, corporate zero coupon debt security. Corporations often use it to raise money for short-term needs. Investors buy commercial paper at a discount, and the issuer pays back the par value at maturity.
The maximum maturity for commercial paper is 270 days. That number ties to SEC registration rules discussed under the Securities Act of 1933 in the primary market unit. In general, issuers must register new securities with the Securities and Exchange Commission (SEC) before selling them to the public. Registration is designed to require disclosure of important (material) information so investors can make informed decisions.
Registration can be expensive and time-consuming. Issuers typically hire lawyers, accountants, and other professionals to prepare the registration statement, and they must pay filing fees to regulators.
The Securities Act of 1933 provides exemptions (exceptions) to registration. For now, focus on this one: If a bond is issued with 270 days or less to maturity, the issuer is exempt from registering it with the SEC.
Why is commercial paper treated this way? Short-term debt is often considered relatively safe compared with long-term bonds. For an investor to lose the entire investment, the issuer would generally need to go bankrupt within the next 270 days. That’s less likely for the large, well-established companies that typically issue commercial paper.
Commercial paper gives issuers short-term cash and avoids the registration process, which makes issuance relatively straightforward. However, because it must be repaid within 270 days, it’s not a good tool for long-term funding.
Typical investors in commercial paper are large institutions. Because commercial paper is issued in large denominations (typically $100,000 or more), many retail investors can’t buy it directly. Financial institutions may buy commercial paper and package it into products that are accessible to retail investors (for example, money market funds). You’ll see more on this when we cover investment companies later.
A debenture is a long-term, unsecured (naked) corporate bond. This definition matters, and it can appear multiple times on the Series 6 exam.
In terms of risk, debentures are riskier than secured corporate bonds. With no collateral backing them, debentures are full faith and credit bonds. The issuer is legally obligated to repay the borrowed funds, but there is no specific asset that bondholders can claim if the corporation goes bankrupt. Because of this added risk, debentures are typically issued with higher coupons and trade at higher yields (lower prices) than comparable secured bonds.
A debenture is one of many forms of long-term corporate debt, sometimes called funded debt. The term reflects that the corporation has a long period of time to use the borrowed funds.
In finance, the word “guarantee” is usually used cautiously. Still, guaranteed bonds do exist. To understand them, it helps to start with the idea of a subsidiary.
As companies grow, they often operate through separate businesses under a larger corporate umbrella. For example, Crest Toothpaste, Head & Shoulders, and Pampers are subsidiaries of Procter & Gamble. A subsidiary is a company owned and controlled by a larger parent company.
When a subsidiary issues a bond, the parent company may agree to “co-sign” the debt. If the subsidiary can’t repay the bond, the parent company becomes responsible for repayment. For example, if Pampers issued a guaranteed bond, Procter & Gamble would guarantee the bond by agreeing to pay if Pampers can’t.
Even with the parent company’s backing, guaranteed bonds are still considered unsecured bonds. To be secured, a bond must be backed by collateral (a specific asset). A third-party promise to pay is not collateral.
Guaranteed bonds can also refer to bonds insured by third parties, which is most common with municipal bonds. For example, if the city of Denver issues a bond insured by Ambac, the bond is considered “guaranteed.”
Bottom line - any bond backed by a third party’s promise to pay (whether a parent company or an insurance company) is considered a guaranteed bond.
Income bonds, sometimes called adjustment bonds, are risky bonds that come out of bankruptcy. Suppose a corporation issues bonds and later defaults, meaning it can’t make required interest and principal payments. Bondholders may sue the issuer and bring the company into bankruptcy court.
Bankruptcy is complex, but the basic idea is straightforward. Bondholders generally push for one of two outcomes:
If bondholders believe the business won’t recover, they may seek liquidation. This happened with Sports Authority when creditors forced the company to shut down instead of continuing operations.
When liquidation payouts are made, payments follow the priority order discussed earlier in this chapter.
If bondholders believe the issuer might recover, they may allow the company to restructure its debt and issue income bonds.
Restructuring is complicated, but here’s the key point for the exam: income bonds are issued after bankruptcy, and they only pay interest if the company has sufficient earnings. In the process, the corporation typically cancels (“destroys”) the old bonds and replaces them with new income bonds. The new bonds may have different features, interest rates, and par values than the original bonds.
After bankruptcy court, the issuer continues operating. If it becomes profitable again, it may begin making interest payments to income bondholders.
However, many issuers that restructure never return to consistent profitability. If the issuer doesn’t meet the earnings requirement, income bonds may pay no interest and may ultimately become worthless.
Income bonds are generally considered poor investments and are suitable only for very aggressive, highly risk-tolerant investors. They typically trade at very high yields (low prices).
For suitability questions on the exam, income bonds are almost always the wrong answer. The name can be misleading: “income” sounds like reliable interest payments, but these bonds often don’t pay.
Mortgage bonds are the first type of secured (collateralized) bond we’ll cover in detail. When a corporation issues a mortgage bond, it pledges real estate as collateral. Examples include factories and other corporate real estate.
Issuers use mortgage bonds to lower their borrowing costs. If an issuer sells debentures, investors take on more risk because there’s no collateral, so they demand higher interest rates. By pledging real estate, the issuer can often borrow at a lower rate - but it risks losing the property if it can’t pay the bond.
Utility companies are common issuers of mortgage bonds because they often own valuable property that can serve as collateral. Mortgage bonds may be backed by factories, electrical grids, and power plants.
First mortgage bonds and second mortgage bonds describe priority if the collateral must be liquidated. If the issuer can’t make payments and the real estate collateral is sold:
Because second mortgage bonds are lower in priority, they are riskier, trade at lower prices, and offer higher yields.
Equipment trust certificates (ETCs) are also secured bonds. If a corporation issues bonds backed by the equipment it owns, it has issued ETCs. Collateral could include vehicles, construction equipment, or airplanes. For example, Delta Airlines sells bonds and pledges some of its airplanes as collateral. Interestingly enough, their bond ratings* have declined due to COVID-19’s effect on the value of airplanes.
*Bond ratings were covered in the debt securities suitability chapter.
Collateral trust certificates (CTCs) are bonds secured by marketable assets owned by the corporation. Marketable assets could include a portfolio of investments or a subsidiary.
For example, PepsiCo could issue a bond and pledge Gatorade (a subsidiary of theirs) as collateral. If PepsiCo doesn’t make the required bond payments, Gatorade becomes the property of the bondholders. In most cases, Gatorade would be liquidated (sold), and the proceeds would be used to repay bondholders.
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