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 (equity), which means the company gives up some ownership. The main benefit of selling stock is that the money raised doesn’t have to be repaid. The main drawback is that ownership is diluted, and shareholders gain voting rights and approval power over many corporate decisions.
When a corporation borrows by issuing debt securities (like bonds), there are also pros and cons. The key benefit is that the corporation doesn’t give up ownership and can continue to run the company as it sees fit. Bondholders (lenders) generally have no say in business operations unless the bond defaults. If a default occurs, bondholders may influence certain post-bankruptcy decisions (for example, whether the company liquidates or continues operations).
The key drawback to raising capital through debt is that the corporation must repay the borrowed funds with interest. Even low interest rates can translate into large dollar payments when the borrowing amount is large.
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 reflects the perceived strength of companies of this size. Still, 0.4% interest on $1 billion means Amazon pays $4 million in interest each year.
In this chapter, we’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. 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, the next category is secured creditors, which is where collateralized bonds fall. These bonds are backed by a specific asset (collateral). If the issuer fails to make interest or principal payments, that collateral can be liquidated to help repay the bondholders.
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 does not fully cover the loan balance, the liquidation priority above applies to the remaining unpaid balance.
To demonstrate this, assume a secured creditor is owed $1,000, $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. This is where unsecured bonds, also known as full faith and credit bonds, fall. If a bond has no collateral backing its issue, it is unsecured. Because unsecured creditors are paid after secured creditors, unsecured bonds generally carry more risk than secured (collateralized) bonds.
After unsecured creditors come 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 that you don’t need to worry about, issuers are sometimes required to issue subordinated (junior) bonds. These bonds carry more risk than debentures because they have no collateral and are paid after other unsecured creditors.
After the creditors, we have stockholders. Preferred stockholders come first, and common stockholders are last. Stockholders are 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.
Finance professionals often use shorthand when discussing securities. Markets move quickly, so there’s an incentive to communicate information as efficiently as possible. 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 would probably say something like:
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 something like:
The ABC corporate bond is trading at 95 .
They’re saying the bond is trading at $955. Compare what’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.
How do you turn a fractional corporate bond quote into a dollar price? You can do it using 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
Think you can do it on your own? Give it a try!
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
As you can see, both quotes above are in eighths and reduced to the lowest possible fraction.
Corporate bond quotes are percentage of par quotes, meaning they’re stated as a percentage of the bond’s par value. If a bond is quoted at 98, it means the 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. But bonds trade at many different prices. When a bond’s price doesn’t land exactly on a $10 increment, fractions are used. For example, a price of $987.50 translates to a quote of 98 .
Percentage of par quotes utilize bond points.
Again, if a bond is worth 98 bond points, it’s worth $980 (98 x $10). You’ll hear different terms for these quotes, but the math is the same. Whether it’s called a percentage of par quote or a bond point quote, both describe the bond’s market price.
Bond quotes may also contain the letter ‘M.’ For example:
10M bond trading at 95 .
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:
or
To keep it as simple as possible with ‘M,’ pretend it’s not there. Buying a 10M bond is the same as buying ten $1,000 par bonds. It’s just another piece of bond shorthand.
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
You should already feel comfortable with three parts of this quote:
Let’s discuss the two new elements. 10s references the bond’s coupon (interest rate). Replace the ‘s’ with %, and you have a 10% coupon bond. That means it pays $100 of interest per $1,000 of par value each year.
This is a $5,000 par bond, so it pays $500 in annual interest (10% x $5,000).
It’s also possible to 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
We also see another ‘M,’ this time as M’40. When you encounter the letter ‘M’ followed by an apostrophe and a number, the quote is referencing the maturity year. 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 66. For test purposes, just know corporate and municipal bonds are quoted in terms of price (in 1/8ths).
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