Commercial paper, sometimes described as a type of promissory note, is short-term, corporate zero coupon debt. Corporations use it to raise money for short-term needs. Investors buy commercial paper at a discount, and the issuer repays par value at maturity.
The maximum maturity for commercial paper is 270 days. That number ties directly to securities registration rules.
In the laws and regulations unit, you’ll cover the Securities Act of 1933 and the Uniform Securities Act. These laws regulate the sale of new issues. In general, issuers must register securities with the Securities and Exchange Commission (SEC) and/or the state administrator 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 required filings, and they also pay filing fees to regulators. Because of that cost, issuers generally register only when they must.
Both the SEC and state administrators offer exemptions (exceptions) from registration. There are several exemptions you’ll learn later. 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.
*If you’re really curious, here are the links to the chapters covering these exemptions:
Why do regulators allow this exemption? Short-term debt generally carries less risk than long-term debt. For an investor to lose the entire investment, the issuer would have to go bankrupt within the next 270 days. For the typical issuers of commercial paper - large, well-established companies - that outcome is less likely.
Commercial paper gives issuers quick access to short-term cash, and avoiding registration makes issuance relatively simple. Because it must be repaid within 270 days, it isn’t a good tool for long-term financing.
Typical investors in commercial paper are large institutions. Because commercial paper is issued in large denominations (often $100,000 or more), many retail investors can’t buy it directly. However, large financial institutions may buy commercial paper and repackage it into more accessible investments for retail investors. You’ll see how that works when you study investment companies later.
A debenture is a long-term, unsecured (naked) corporate bond. This definition matters on the Series 65 exam and tends to show up in multiple contexts.
In terms of risk, debentures are riskier than secured corporate bonds because there is no collateral backing them. Debentures are full faith and credit bonds: the issuer is legally obligated to repay, but bondholders don’t have a specific pledged asset to claim if the corporation goes bankrupt. Because investors take on more risk, debentures generally offer higher coupons and trade at higher yields (lower prices).
A debenture is one of many forms of long-term corporate debt, which is 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 - investments rarely come with true guarantees. However, guaranteed bonds do exist. To understand them, you need the idea of a subsidiary.
As companies grow, they often operate through separate business units. 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 act like a co-signer. If the subsidiary can’t repay the bond, the parent becomes responsible for repayment. For example, if Pampers issues a guaranteed bond, Procter & Gamble “guarantees” it by obligating itself to pay if Pampers can’t.
Even with the parent company’s backing, guaranteed bonds are still considered unsecured bonds. A bond is secured only when specific collateral (a valuable asset) is pledged. A third party’s promise to pay is support, but it isn’t collateral.
The term guaranteed bond can also apply to bonds insured by third parties, most commonly 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 (whether a parent company or an insurance company) is considered a guaranteed bond.
Income bonds, sometimes called adjustment bonds, are high-risk bonds that come out of bankruptcy. Suppose a corporation issues bonds and later defaults, meaning it can’t make the required interest and principal payments. Bondholders may sue and push the issuer into bankruptcy court.
Bankruptcy court is complex, but the basic idea is straightforward. Bondholders generally have two paths:
If bondholders believe the business won’t recover, they may seek liquidation. Liquidation means the company sells its assets (such as real estate, equipment, and inventory) and uses the proceeds to repay creditors as much 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.
Liquidation ends the business. But if bondholders believe the issuer might recover, they may allow the company to restructure its debt. One possible outcome of restructuring is the issuance of income bonds.
Restructuring is complicated, but the key point is the role of income bonds. In the process, the issuer effectively replaces the old defaulted bonds with new income bonds. These new bonds pay interest only if the company has sufficient earnings. Income bonds may also 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. If the turnaround succeeds, both the business and the bondholders benefit.
However, many issuers that restructure never return to sustained profitability. In that case, income bonds may never pay interest or principal, and they can become worthless.
Income bonds are generally poor investments and are typically appropriate only for the most risk-tolerant investors. They trade at very high yields (low prices) in the market.
If you see a suitability question on the exam, income bonds are almost always the wrong answer. Adjustment bonds are suitable only in rare situations for aggressive, risk-tolerant investors willing to take a speculative risk. The name can be misleading: “income” sounds like reliable interest payments, but these bonds often pay nothing.
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 of collateral include factories, equipment, and corporate real estate.
Issuers use mortgage bonds to reduce their cost of borrowing. With debentures, investors take on more risk because there is no collateral, so they demand higher interest rates. By pledging real estate, the issuer can usually borrow at a lower interest rate - but it risks losing the pledged property if it can’t repay the bond.
Utility companies are common issuers of mortgage bonds. These companies often own valuable property that can be pledged as collateral, such as factories, electrical grids, and power plants.
First mortgage bonds describe priority if the collateral must be liquidated. If the issuer can’t make required payments, the pledged real estate may be sold. First mortgage bondholders receive sale proceeds first until they are paid in full. Any remaining proceeds go to second mortgage bonds. Because second mortgage bonds have lower 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 can include vehicles, construction equipment, or airplanes. For example, Delta Airlines can issue bonds and pledge 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 are covered in the 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.
Sign up for free to take 5 quiz questions on this topic