Corporations borrow vast amounts of money for a wide variety of reasons. Here are some real-world examples:
When corporations need money, they typically raise capital in one of two general ways: equity and debt. We’ve already discussed selling stock, which results in the company giving up ownership. The benefit of selling stock is the capital raised never has to be repaid. The drawback is giving up ownership, which results in required shareholder approval for many corporate decisions.
When a corporation borrows through issuing debt securities like bonds, there also are pros and cons. The benefit is the corporation does not lose ownership and can run the company as they see fit. Bondholders (lenders) have no say in business operations unless the bond defaults. If a default occurs, bondholders influence some post-bankruptcy decisions (for example, if the company will liquidate or continue operations).
The drawback to raising capital through debt is having to pay back the borrowed funds with interest. Even low interest rates result in large amounts of money for large issuances. In the Amazon example cited above, part of the offering included a 3-year, $1 billion note issued at an interest rate of 0.4%. Amazon broke records for the lowest interest rate a corporation has ever borrowed at, which is a testament to how strong a company Amazon is. Still, a 0.4% interest rate on $1 billion results in Amazon paying $4 million in interest annually!
In this chapter, we’ll learn about several different types of corporate debt, including:
As you can see, there are several types of debt securities that corporations can issue to raise capital. Each comes with its own set of benefits and risks, which we’ll discuss throughout this chapter.
We originally discussed the liquidation priority of corporations in the common stock chapter, but let’s revisit it. If a company is forced to liquidate its assets, it will pay the liquidation funds in this order:
Unpaid wages
Unpaid taxes
Secured creditors
Unsecured creditors
Junior unsecured creditors
Preferred stockholders
Common stockholders
In case you’re wondering, a bondholder is a type of creditor. After unpaid wages and taxes, we have secured creditors, which is where collateralized bonds fall. These bonds have a valuable asset backing their issue that can be liquidated if the issuer fails to make interest or principal payments.
There can be some confusion related to the order of unpaid wages & taxes vs. secured creditors depending on the source of information. Secured creditors have first rights to the collateral backing the loan. If the collateral backing the loan is liquidated and does not cover the loan balance, the liquidation priority above applies.
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 & taxes vs. secured creditors is not a heavily tested concept. Questions on the priority of creditors (bondholders) vs. equity holders (stockholders) are much more common on the exam.
Unsecured creditors are next, which is where unsecured bonds, also known as full faith and credit bonds, fall. If a bond does not have any collateral backing its issue, it is unsecured. Because these bonds fall second on the priority list, they are riskier than secured (collateralized) bonds.
After unsecured creditors, we have junior unsecured creditors, also known as subordinated debenture holders. These are the same as regular debentures, with the exception of where they fall in liquidation priority. For legal reasons that you don’t need to worry about, issuers are sometimes forced to issue subordinated (junior) bonds. They come with more risk than debentures as they fall lower in priority and have no collateral backing them.
After the creditors, we have our stockholders. Preferred stockholders come first, with common stockholders falling last on the priority scale. Stockholders are considered owners of the company, and owners “go down with the ship.” When a company goes through a liquidation, there is typically little to no money left for stockholders.
Commercial paper, sometimes referred to as a type of promissory note, is a type of short term, corporate zero coupon debt security. If a corporation needs to raise money for short-term purposes, issuing commercial paper is a great way to do it. Investors purchase commercial paper at a discount and the issuer pays back the par value at maturity.
The maximum maturity for commercial paper is 270 days. It may seem like a random amount of time, but it relates to something specific. In the primary market unit, we’ll discuss the Securities Act of 1933. This law covers the sale of new issues. Issuers are typically required to register securities with the Securities and Exchange Commission (SEC) prior to public sale. The purpose of registration is to force issuers to disclose all important (material) facts about the security in order to provide the public with enough information to make an informed investment decision.
Registration involves significant amounts of time and money. The issuer will hire lawyers, accountants, and other professionals to help them fill out registration forms. In addition, the issuer must pay fees to the regulators to simply file the form. This is an exhausting process that is only done if absolutely required.
The Securities Act of 1933 provides exemptions (exceptions) to their registration process. There are a number of exemptions that are important to know and will be discussed later in this material. For now, we’ll only focus on one of them. If a bond is issued with 270 days or less to maturity, the issuer is exempt from registering it with the SEC.
Why don’t the regulators require corporate issuers to register commercial paper? Short-term debt securities are usually very safe and avoid many of the risks that investors assume with long-term bonds. In order for the purchaser to lose their entire investment, the issuer would need to go bankrupt within the next 270 days. This is unlikely to happen to larger, well-established companies, which are the typical issuers of commercial paper.
Commercial paper provides issuers with short-term cash. By avoiding the registration process, issuing this type of debt is a fairly simple process. Issuers must repay the borrowed funds within 270 days, so issuing commercial paper isn’t a great option for a company looking for long-term funding.
Typical investors in commercial paper are large institutions. Due to their large denominations, typically $100,000 or more, many retail investors cannot afford commercial paper. However, large financial institutions buy and repackage them into affordable investments for retail investors (e.g. money market funds). When we discuss investment companies later, you’ll learn more about this.
A debenture is a long-term, unsecured (naked) corporate bond. Knowing the definition of a debenture is more important than it may seem initially and can show up several 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 their borrowed funds, but there is no asset of value that the bondholders can access should the corporation go bankrupt. Due to this risk, debentures are sold with higher coupons and traded in the market at higher yields (lower prices).
A debenture is one of many forms of long-term corporate debt, which is sometimes referred to as funded debt. The term relates to corporations having long periods of time to utilize funds raised through a bond issuance.
Generally speaking, you’ll want to avoid the word “guarantee” in finance. There are no guarantees when it comes to investing. However, guaranteed bonds do exist. To understand these, we’ll first need to discuss the idea of a subsidiary.
When companies grow, they tend to become compartmentalized. For example, Crest Toothpaste, Head & Shoulders, and Pampers are subsidiaries of Procter & Gamble. In fact, many of the products under your kitchen sink are created by companies owned by Procter & Gamble. A subsidiary is a company owned and controlled by a larger, “parent” company.
When a subsidiary of a larger company issues a bond, it can obtain a “co-signer” with its parent company. If the subsidiary cannot repay the borrowed funds, the parent company becomes responsible for doing so. For example, if Pampers issues a guaranteed bond, Procter & Gamble will “guarantee” the bond by obligating themselves to pay off the bond if Pampers cannot.
Although guaranteed bonds come with the parent company’s backing, they are still considered unsecured bonds. Essentially, the bond’s success or failure is contingent on the parent company’s ability to pay off the bond. A bond must have collateral (a valuable asset) to be secured, and a promise to pay from another company doesn’t count as collateral.
Guaranteed bonds can also refer to bonds insured by third parties, which most commonly occurs with municipal (state and city government) bonds. For example, if the city of Denver issues a bond that is insured by Ambac (an insurance company), the bond is “guaranteed.”
Bottom line - any bond with backing from a third party (whether it’s a parent company or insurance company) is considered a guaranteed bond.
Income bonds, sometimes referred to as adjustment bonds, are risky bonds that come out of bankruptcy. Let’s assume a corporation issues a bond, but later defaults and is unable to make required interest and principal payments to their bondholders. When this occurs, the bondholders typically sue the issuer and bring them to bankruptcy court.
Bankruptcy court is complicated, but you only need to know the basics. The suing bondholders essentially have two choices: force the issuer to liquidate the company or allow them to “restructure” their debt.
If the bondholders don’t believe the business will ever become successful again, they’ll seek liquidation of the corporation. Liquidation requires the company to sell all of its assets, which could include real estate, equipment, and inventory. Once the company sells its assets, they return as much money back to its creditors (bondholders included) as possible. This happened with Sports Authority when creditors forced the company to completely shut down instead of staying in business.
When liquidation payouts are made, payments are prioritized to specific parties as we discussed earlier in this chapter.
If liquidation occurs, the corporation and its businesses are done. However, what if the bondholders believe the bankrupt issuer may be able to reform and “rise from the ashes?” They can allow them to restructure their debt and issue income bonds.
Restructuring debt is complicated, but you’ll only need to be aware of income bonds and their role in the process. Before issuing income bonds, the corporation will first “destroy” its old bonds. Then, they issue new income bonds to their bondholders that only pay interest if the company has sufficient earnings. Income bonds can potentially have different features, interest rates, and par values than the original failed bonds.
After bankruptcy court, the issuer gets back to their business. If they’re profitable again, they’ll begin to make interest payments to the income bondholders. It’s possible that the corporation fixes its problems, which would be a win for both the income bondholders and the business.
Unfortunately, most income bonds don’t turn out that way. When a company goes bankrupt and is allowed to restructure, they often never attain a profitable status again. If this were to occur, their income bonds would never pay interest or principal. It’s fairly common for income bonds to become worthless.
Income bonds are generally bad investments that should only be purchased by the most risk-tolerant investors. They sell at very high yields (low prices) in the market.
If you get a suitability question on the exam, income bonds are almost always the wrong answer. Adjustment bonds are suitable only in very rare situations with aggressive and risk-tolerant investors looking to “roll the dice.” The test writers know income bonds are tricky because of the ‘income’ in their name. To the untrained eye, it seems like they’re bonds that pay income, when they most often don’t. Be aware of this trick!
Mortgage bonds are the first type of secured (collateralized) bond we’ll discuss in detail. When a corporation issues a mortgage bond, they pledge real estate as collateral for the bond. Examples of specific collateral include factories, equipment, and corporate real estate.
Issuers sell mortgage bonds as a way to lower their overall cost of borrowing money. If an issuer sells debentures, investors take on more risk with no collateral and demand higher interest rates. By pledging real estate, the issuer can easily lower their interest rate, but will lose their property if they cannot pay off the bond.
Utility companies are common issuers of mortgage bonds. Many times, these organizations own significant amounts of valuable property that offer them a quick and easy way to secure their bonds. There are several examples of utility companies issuing mortgage bonds that are backed by factories, electrical grids, and power plants:
All of the examples above refer to first mortgage bonds, which relates to priority if a liquidation of the collateral occurs. Assume an issuer of mortgage bonds is unable to repay interest and principal to its bondholders. In this case, the company is forced to liquidate (sell) the real estate collateral backing the bond. First mortgage bondholders receive the proceeds of the sale first, until they’re made whole. After, any leftover proceeds are sent to investors in second mortgage bonds. Because they’re lower on the priority scale, second mortgage bonds are riskier, trade at lower prices in the market, and provide higher yields to their investors.
Equipment trust certificates (ETCs) are also secured bonds. If a corporation issues a bond backed by the equipment they own, they’ve 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 that are secured by marketable assets owned by the corporation. Types of 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 the 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 pay back bondholders.
We first learned about convertible securities in the preferred stock chapter. Both preferred stock and corporate bonds can be convertible into stock of the same issuer. For example, a convertible Ford bond would allow the bondholder to convert their bond into Ford stock at any time.
Conversion features provide the investor with another way to make money on their bond. The bond’s yield provides a return, and additionally, the investor can make capital gains on the stock if they convert.
When a convertible bond is issued, the issuer sets its conversion ratio and conversion price. In plain English, both tell the investor how many shares of stock are received if the bond is converted. They are set when the issuer originally sells the bond and typically stay fixed through the life of the bond.
The conversion price is only useful in finding the conversion ratio. For example:
A convertible bond has a conversion price of $40. What is the conversion ratio?
Doing some quick math provides a *conversion ratio of 25:1 (one bond can be converted into 25 shares of common stock). The conversion ratio is important for any convertible bond math-based question. If the conversion price is provided in the question, use the formula above to find the conversion ratio.
If the question provides the conversion ratio, then there’s no need to do the conversion ratio formula. It tells you exactly how many shares are received when the bond is converted.
However, it’s possible you see a question that provides the conversion ratio and asks for the conversion price. For example:
A convertible bond has a conversion ratio of 20:1. What is the conversion price?
As you can see, it’s very similar to the conversion ratio formula. Conversion price trades places with conversion ratio, and that’s it!
Let’s switch gears and learn how an investor may make a capital gain from converting their bond.
A corporate bond has a conversion ratio of 10:1 and is purchased for $900
The investor could make a profit on the conversion if the common stock price were to rise above $90. They’re basically buying a “pack of 10 stocks” for $900. Break it down on a per-share basis:
If the market price of the common stock rises above $90, the investor would make a profit from converting.
A corporate bond has a conversion ratio of 10:1 and is purchased for $900. After a few years, the common stock price rises to $120. If the bond is converted and the common shares are sold, what is the profit?
Can you figure it out?
Step 1: factor in bond purchase
Step 2: find the conversion value
Step 3: compare conversion value to the original purchase
As you can see, convertible bonds provide an extra potential for return. Because of this, convertible bonds are sold with lower interest rates and traded at lower yields (higher prices) in the market.
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