Review

Corporations borrow large amounts of money for many reasons. Here are a few real-world examples:

• Amazon borrows $10 billion for general corporate purposes
• Disney borrows $6 billion to assist company finances during COVID-19
• AT&T raises $12.5 billion to refinance old bonds at a lower rate

When corporations need money, they typically raise capital in one of two general ways: equity and debt.

• Equity means selling ownership (stock). The main advantage is that the money raised doesn’t have to be repaid. The tradeoff is giving up ownership, which can also mean shareholders must approve many major corporate decisions.
• Debt means borrowing money, usually by issuing debt securities such as bonds. The main advantage is that the corporation doesn’t give up ownership and can generally operate without input from bondholders. Bondholders (lenders) don’t vote on business operations unless the issuer defaults. If a default occurs, bondholders may influence certain post-bankruptcy decisions (for example, whether the company liquidates or continues operating).

The main drawback of raising capital through debt is that the corporation must repay the borrowed funds with interest. Even a low interest rate can mean large dollar payments when the borrowing amount is large.

For example, in the Amazon offering cited above, part of the issuance included a 3-year, $1 billion note with an interest rate of 0.4%. That rate was extremely low for a corporate borrower, reflecting Amazon’s strong credit. Even so, 0.4% interest on $1 billion means Amazon pays $4 million in interest each year.

In this chapter, you’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
• Convertible bonds

Corporations can issue many different kinds of debt securities to raise capital. Each type comes with its own benefits and risks, and we’ll work through those throughout this chapter.

We originally discussed the liquidation priority of corporations in the common stock chapter, but it’s worth revisiting here. If a company is forced to liquidate its assets, it pays out liquidation proceeds in this order:

1. Unpaid wages

2. Unpaid taxes

3. Secured creditors

4. Unsecured creditors

5. Junior unsecured creditors

6. Preferred stockholders

7. Common stockholders

A bondholder is a type of creditor.

After unpaid wages and taxes, the next group 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 debt.

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 doesn’t fully cover the loan balance, the liquidation priority above applies to the remaining unpaid amount.

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 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 come next. This is where unsecured bonds, also known as full faith and credit bonds, fall. If a bond has no collateral backing it, it’s 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 they rank lower in liquidation priority. For legal reasons that you don’t need to focus on here, issuers are sometimes required to issue subordinated (junior) bonds. These bonds have more risk than regular debentures because they have no collateral and are paid later in liquidation.

After creditors, the remaining claimants are stockholders. Preferred stockholders are paid before common stockholders, and common stockholders are last in line. Stockholders are owners of the company, so they’re paid only after creditors have been satisfied. In bankruptcy, there is often little to no money left for stockholders.