Income bonds

Income bonds, sometimes referred to as adjustment bonds, are risky bonds that come out of bankruptcy. Let’s assume a corporation issues a bond, but later defaults and is unable to make required interest and principal payments to its bondholders. When this occurs, the bondholders typically sue the issuer and bring them to bankruptcy court.

Bankruptcy court is complicated, but you only need to know the basics. The suing bondholders essentially have two choices: force the issuer to liquidate the company or allow them to “restructure” their debt.

If the bondholders don’t believe the business will ever become successful again, they’ll seek liquidation of the corporation. Liquidation requires the company to sell all of its assets, which could include real estate, equipment, and inventory. Once the company sells its assets, they return as much money back to its creditors (bondholders included) 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 learned in the common stock chapter and the liquidation policy section earlier.

If liquidation occurs, the corporation and its businesses are done. However, what if the bondholders believe the bankrupt issuer may be able to reform and “rise from the ashes?” They can allow them to restructure their debt and issue income bonds.

Restructuring debt is complicated, but you’ll only need to be aware of income bonds and their role in the process. Before issuing income bonds, the corporation will first “destroy” its old bonds. Then, they issue new income bonds to their bondholders that only pay interest if the company has sufficient earnings. Income bonds can potentially have different features, interest rates, and par values than the original failed bonds.

After bankruptcy court, the issuer gets back to their business. If they’re profitable again, they’ll begin to make interest payments to the income bondholders. It’s possible that the corporation fixes its problems, which would be a win for both the income bondholders and the business.

Unfortunately, most income bonds don’t turn out that way. When a company goes bankrupt and is allowed to restructure, many times they never attain a profitable status again. If this were to occur, their income bonds never pay interest or principal. It’s fairly common for income bonds to become worthless.

Income bonds are generally bad investments that should only be purchased by the most risk-tolerant investors. They sell at very high yields (low prices) in the market.

If you get a suitability question on the exam, income bonds are almost always the wrong answer. Adjustment bonds are suitable only in very rare situations with aggressive and risk-tolerant investors looking to “roll the dice.” The test writers know income bonds are tricky because of the ‘income’ in their name. To the untrained eye, it seems like they’re bonds that pay income when they most often don’t. Be aware of this trick!