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 to 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 by 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:
Commercial paper
Debentures
Guaranteed bonds
Income bonds
Mortgage bonds
Equipment trust certificates
Collateral trust certificates
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 again. 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 bankrupt, there is typically little to no money left for stockholders.
Bond quotes
Finance professionals speak what feels like a foreign language when discussing securities. Due to the fast-paced nature of the markets, there’s an incentive to convey information as fast as possible. When a quote is given on a security, it’s stating what the current market value is.
Sometimes quotes are simple, like they usually are with common stock. If you called your broker asking for a quote on a stock, they would probably say something like:
ABC stock is trading at $50 per share.
Bond quotes are more complex and difficult to understand initially. If you were to call your broker and ask for a quote on a corporate bond, they may say something like:
The ABC corporate bond is trading at 95 21.
They’re really saying the bond is trading at $955. Think about it - which can you say faster?
Ninety five and a half (95 21)
vs.
Nine hundred fifty-five dollars ($955)
Corporate bonds are quoted in 81ths (eighths). When asked to identify a corporate bond quote, you should look for a big number followed by a fraction (like 95 21). The fraction following the big number should always be in eighths or reduced from an eighth (for example, 84 would be reduced to 21). If the fraction isn’t in eighths or isn’t reduced, it isn’t a valid corporate bond quote.
How do you turn a fractional corporate bond quote into a price? You can easily do it using Achievable’s “fraction-boot-scoot” method. Let’s walk through an example:
A corporate bond is quoted at 102 81. What is its price?
Step 1: calculate the fraction
81 = 0.125
Step 2: boot the decimal back to the big number
102 + 0.125 = 102.125
Step 3: scoot the decimal once over to the right
$1,021.25
Think you can do it on your own? Give it a try!
A bond is quoted at 98 43. What is its price?
(spoiler)
Answer = $987.50
Step 1: calculate the fraction
43 = 0.75
Step 2: boot the decimal back to the big number
98 + 0.75 = 98.75
Step 3: scoot the decimal once over to the right
$987.50
As you can see, both of the quotes listed above are in eighths and reduced to the lowest possible fraction. Corporate bonds quotes are percentage of par quotes, which means they relate back to their par value. If a bond is quoted at 98, it’s really saying a bond is trading at 98% of par ($1,000), which is $980.
If bonds only traded in $10 denominations, there would be no need for fractions. However, the market trades bonds at various prices. When a bond does not trade in $10 increments, that’s when fractions are utilized. Our example bond quote above is trading at $987.50, which translates to a quote of 98 43.
Percentage of par quotes utilize bond points.
Again, if a bond is worth 98 bond points, it’s really worth $980 (98 x $10). There are various ways to refer to these quotes, but it always works the same way. Whether it’s referred to as a percentage of par quote or a bond point quote, both refer to a bond’s market price.
Bond quotes may also contain the letter ‘M.’ For example:
10M bond trading at 95 21.
The ‘M’ refers to the overall par value of the bond being quoted, specifically in $1,000 units (M is the Roman numeral for 1,000). Therefore, the bond quote above translates to:
Ten $1,000 par bonds trading for $955 each
or
$10,000 par value bond trading for $9,550
To keep it as simple as possible with ‘M,’ pretend it’s not there. Buying a 10M bond is no different than buying ten $1,000 par bonds. It’s just another part of bond language that attempts to efficiently convey information.
There are a few other elements of a corporate bond quote to be aware of. Here’s an example of a full quote:
5M 10s ABC Debenture M’40 @ 95 21
You should already feel comfortable with three parts of this quote:
5M = $5,000 par (or 5 $1,000 par bonds)
ABC Debenture = Long term unsecured bond from ABC Company
95 21 = Trading at $955
Let’s discuss the two new elements. 10s references the bond’s coupon (interest rate). Simply replace the letter ‘s’ with %, and you have a 10% coupon bond that will pay $100 in interest for per every $1,000 par. This is a $5,000 par bond, so it will pay $500 in annual interest (10% x $5,000).
It’s possible you could also see a quote reference a zero coupon bond. Instead of a number followed by the letter ‘s,’ it would instead appear as:
5M Zr ABC Debenture M’40 @ 95 21
We also see another ‘M.’ This time, it’s M’40. When you encounter the letter ‘M’ followed by an apostrophe and a number, the quote is referencing the maturity date. This bond matures in the year 2040.
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 utilize yield-based quotes. This is unlikely to be tested on the Series 65. For test purposes, just know corporate and municipal bonds are quoted in terms of price (in 1/8ths).
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