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).
Commercial paper
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 laws and regulations unit, we’ll discuss the Securities Act of 1933 and Uniform Securities Act. Both laws cover the sale of new issues. Issuers are typically required to register securities with the Securities and Exchange Commission (SEC) and/or the state administrator 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.
Both the SEC and state administrator provide 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.
*If you’re really curious, here are the links to the chapters covering these exemptions:
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 for most 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. When we discuss investment companies later, you’ll learn more about this.
Debentures
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 65 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.
Guaranteed bonds
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 itself 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
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 its 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, many times they never attain a profitable status again. If this were to occur, their income bonds 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
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 relate to priority if 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
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.
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.
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