Commercial paper, sometimes described as a type of promissory note, is a short-term, corporate zero coupon debt security. Corporations often use it to raise money for short-term needs. Investors buy commercial paper at a discount, and the issuer repays the 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, which 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.
The purpose of registration is disclosure: it requires issuers to provide all important (material) facts about the security so the public has enough information to make an informed investment decision.
Registration takes significant time and money. Issuers typically hire lawyers, accountants, and other professionals to prepare the filing, and they also pay regulatory filing fees. Because of that cost, issuers generally register only when they must.
Both the SEC and state administrators provide exemptions (exceptions) from registration. There are several exemptions you’ll cover 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 don’t regulators require corporate issuers to register commercial paper? Short-term debt is usually considered relatively safe compared with long-term bonds. For an investor to lose the entire investment, the issuer would generally need to go bankrupt within the next 270 days. For many large, established companies (the typical issuers of commercial paper), that’s less likely than over a longer time horizon.
Commercial paper gives issuers short-term cash, and avoiding registration makes issuance relatively simple. Because the issuer must repay within 270 days, commercial paper isn’t a good tool for long-term funding.
Typical investors in commercial paper are large institutions. Because commercial paper is issued in large denominations, typically $100,000 or more, many retail investors can’t buy it directly. However, large financial institutions may buy commercial paper and repackage it into investments that are accessible to retail investors. When you cover investment companies later, you’ll see how that works.
A debenture is a long-term, unsecured (naked) corporate bond. This definition matters more than it might seem at first, and it can appear multiple times on the Series 66 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 the borrowed funds, but bondholders don’t have a specific pledged asset to claim if the corporation goes bankrupt. Because of this added risk, debentures are typically issued with higher coupons and trade at higher yields (lower prices).
A debenture is one of many forms of long-term corporate debt, sometimes called funded debt. The term reflects that the corporation has a long period of time to use the funds raised through the bond issuance.
In finance, the word “guarantee” is usually something to be cautious with - investing rarely comes with certainty. Still, guaranteed bonds do exist. To understand them, it helps to start with the idea of a subsidiary.
As companies grow, they often become compartmentalized. 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 act like a “co-signer.” If the subsidiary can’t repay the borrowed funds, the parent company becomes responsible for repayment. For example, if Pampers issues a guaranteed bond, Procter & Gamble “guarantees” the bond 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 it has pledged collateral (a valuable asset). A third party’s promise to pay is support, but it isn’t collateral.
Guaranteed bonds can also refer to bonds insured by third parties, most commonly municipal (state and city government) bonds. For example, if the city of Denver issues a bond insured by Ambac, the bond is considered “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, sometimes called adjustment bonds, are risky bonds that come out of bankruptcy. Suppose a corporation issues bonds but later defaults and can’t make required interest and principal payments. Bondholders may sue the issuer, and the dispute can end up in bankruptcy court.
Bankruptcy court is complex, but you only need the basics here. Bondholders generally push for one of two outcomes:
If bondholders don’t believe the business can become successful again, they may seek liquidation. Liquidation requires the company to sell its assets (such as real estate, equipment, and inventory) and distribute as much money as possible to creditors (including bondholders). 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 and issue income bonds.
Restructuring is complicated, but the key point is the role of income bonds. In a restructuring, the corporation first replaces (“destroys”) its old bonds and then issues new income bonds to bondholders. 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.
However, many income bonds don’t work out well. If the company never returns to profitability, the income bonds may never pay interest or principal. It’s fairly common for income bonds to become worthless.
Income bonds are generally poor investments and are typically suitable 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 test writers know income bonds are tricky because of the word “income” in the name - it sounds like they reliably pay income, when they often don’t.
Mortgage bonds are the first type of secured (collateralized) bond covered in detail here. When a corporation issues a mortgage bond, it pledges real estate as collateral for the bond. Examples of collateral include factories, equipment, and corporate real estate.
Issuers use mortgage bonds to reduce their cost of borrowing. If an issuer sells debentures, investors take on more risk because there’s no collateral, so they demand higher interest rates. By pledging real estate, the issuer can often 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 to secure bonds, 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 interest and principal payments, it may be forced to liquidate (sell) the real estate collateral. First mortgage bondholders receive sale proceeds first, until they’re made whole. Any remaining proceeds go to second mortgage bond investors. Because they have lower priority, second mortgage bonds are riskier, trade at lower prices, and offer higher yields.
Equipment trust certificates (ETCs) are also secured bonds. If a corporation issues a bond backed by the equipment it owns, it has 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.
*Bond ratings are covered in the suitability chapter.
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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