Corporations borrow large amounts of money for many reasons. Here are a few real-world examples:
When corporations need money, they typically raise capital in one of two ways: equity and debt.
We’ve already discussed selling stock (equity), which means the company gives up some ownership. The main benefit of selling stock is that the capital raised doesn’t have to be repaid. The main drawback is that giving up ownership can mean shareholders must approve many corporate decisions.
When a corporation borrows by issuing debt securities (such as bonds), there are also pros and cons.
For example, in the Amazon offering 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 reflects how strong a company Amazon is. Still, 0.4% interest on $1 billion means Amazon pays $4 million in interest each year.
In this chapter, you’ll learn about several different types of corporate debt, including:
As you can see, corporations can issue several types of debt securities to raise capital. Each type comes with its own benefits and risks, which we’ll cover throughout this chapter.
We originally discussed the liquidation priority of corporations in the common stock chapter, but let’s revisit it here. If a company is forced to liquidate its assets, it will distribute 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, we have secured creditors, which is where collateralized bonds fall. These bonds are backed by a specific asset (collateral) that can be liquidated 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 unpaid amount.
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 a heavily tested concept. Questions on the priority of creditors (bondholders) versus equity holders (stockholders) are much more common on the exam.
Unsecured creditors are next, which is where unsecured bonds (also called full faith and credit bonds) fall. If a bond has no collateral backing its issue, it is unsecured. Because these bonds rank below secured creditors, they carry more risk than secured (collateralized) bonds.
After unsecured creditors, we have junior unsecured creditors, also known as subordinated debenture holders. These are similar to regular debentures, except for where they fall in liquidation priority. For legal reasons you don’t need to focus on here, issuers are sometimes required to issue subordinated (junior) bonds. These bonds carry more risk than debentures because they rank lower in priority and have no collateral backing.
After the creditors, we have stockholders. Preferred stockholders come first, and common stockholders fall last on the priority scale. Stockholders are owners of the company, and owners are paid only after creditors. When a company goes bankrupt, there is typically little to no money left for stockholders.
Finance professionals often use shorthand when discussing securities. Markets move quickly, so quotes are designed to communicate information efficiently. A quote tells you the security’s current market value.
Sometimes quotes are simple, like they usually are with common stock. If you called your broker asking for a quote on a stock, they might say:
ABC stock is trading at $50 per share.
Bond quotes are more complex at first. If you called your broker and asked for a quote on a corporate bond, they might say:
The ABC corporate bond is trading at 95 .
They mean the bond is trading at $955. It’s faster to say:
Ninety five and a half (95 )
vs.
Nine hundred fifty-five dollars ($955)
Corporate bonds are quoted in ths (eighths). When you’re asked to identify a corporate bond quote, look for a large number followed by a fraction (like 95 ). The fraction should be in eighths or reduced from eighths (for example, would be reduced to ). If the fraction isn’t in eighths (or reduced from eighths), it isn’t a valid corporate bond quote.
To convert a fractional corporate bond quote into a dollar price, you can use Achievable’s “fraction-boot-scoot” method. Here’s an example:
A corporate bond is quoted at 102 . What is its price?
Step 1: calculate the fraction
Step 2: boot the decimal back to the big number
Step 3: scoot the decimal once over to the right
Try one on your own:
A bond is quoted at 98 . What is its price?
Answer = $987.50
Step 1: calculate the fraction
Step 2: boot the decimal back to the big number
Step 3: scoot the decimal once over to the right
Both quotes above are in eighths (or reduced from eighths). Corporate bond quotes are percentage of par quotes, meaning they’re stated as a percentage of the bond’s par value.
If bonds only traded in $10 increments, there would be no need for fractions. But bonds trade at many different prices. When the price isn’t an even $10 increment, fractions are used. For example, a price of $987.50 corresponds to a quote of 98 .
Percentage of par quotes use bond points.
So if a bond is worth 98 bond points, it’s worth $980 (98 x $10). You may hear these described as “percentage of par” quotes or “bond point” quotes, but both refer to the bond’s market price.
Bond quotes may also include the letter M. For example:
10M bond trading at 95 .
Here, M refers to the overall par value being quoted in $1,000 units (M is the Roman numeral for 1,000). So the quote translates to:
or
To keep it simple, treat the M as a sizing label. Buying a 10M bond is the same as buying ten $1,000 par bonds.
There are a few other elements of a corporate bond quote to know. Here’s an example of a full quote:
5M 10s ABC Debenture M’40 @ 95
You should already be comfortable with three parts of this quote:
Now for the two new elements:
You might also see a quote for a zero coupon bond. Instead of a number followed by “s,” it would appear as:
5M Zr ABC Debenture M’40 @ 95
Many municipal bonds are quoted the same way corporate bonds are. If you’ve previously taken the Series 7, you might remember some municipal bonds use yield-based quotes. This is unlikely to be tested on the Series 65. For test purposes, know that corporate and municipal bonds are quoted in terms of price (in 1/8ths).
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