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, 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:
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 from 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.
Sign up for free to take 8 quiz questions on this topic