Income bonds, sometimes called adjustment bonds, are high-risk bonds that may be issued after a company goes through bankruptcy.
Suppose a corporation issues bonds but later defaults and can’t make the required interest and principal payments. When that happens, bondholders typically sue the issuer and the case moves to bankruptcy court.
Bankruptcy court can get complex, but the basic idea is straightforward. The bondholders generally push for one of two outcomes:
If the bondholders don’t believe the business can become successful again, they’ll seek liquidation. Liquidation means the company sells its assets (such as real estate, equipment, and inventory). The proceeds are then distributed to creditors (including bondholders) as far as the money will go. 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.
The other possibility is that bondholders believe the issuer might recover. In that case, they may allow the company to restructure its debt, which can include issuing income bonds.
Restructuring is a broad process, but here’s the part you need to know for the exam. In a restructuring:
Income bonds may also have different features than the original bonds, including different interest rates and par values.
After the bankruptcy case, the issuer continues operating. If the company becomes profitable again, it can begin making interest payments to the income bondholders. In the best-case scenario, the business recovers and bondholders receive interest.
More often, though, the company never returns to sustained profitability. If that happens, the income bonds may never pay interest, and they may also fail to return principal. It’s fairly common for income bonds to become worthless.
Because of this, income bonds are generally poor choices for most investors. They typically trade at low prices and therefore show very high yields, reflecting their high risk.
On suitability questions, income (adjustment) bonds are almost always the wrong answer. They’re suitable only in rare cases for aggressive, highly risk-tolerant investors who are willing to accept a significant chance of receiving no interest.
One common exam trap is the word income in the name. It can sound like a bond designed to provide steady income, but these bonds often don’t pay interest at all.
Sign up for free to take 3 quiz questions on this topic