Long-term products

We’ll now discuss various types of long-term corporate debt with maturities ranging from 3 to 40 years. When a corporate issuer has access to their borrowed funds for an extended period, their debt is considered “funded.”

Debentures

A debenture is a long-term, unsecured (naked) corporate bond. Debentures are riskier than secured corporate bonds. The issuer is legally obligated to repay their borrowed funds, but there is no valuable asset the bondholders can access should the corporation go bankrupt. Due to this risk, debentures are typically issued with higher coupons and trade at higher yields (lower prices) than similar secured corporate bonds.

Guaranteed bonds

Generally speaking, you’ll want to avoid the word “guarantee” in the securities industry, as investors are never guaranteed to make money. However, guaranteed bonds do exist. To understand these, we’ll first need to discuss the idea of a subsidiary.

When companies grow, they tend to become compartmentalized. For example, Crest Toothpaste, Head & Shoulders, and Pampers are subsidiaries of Procter & Gamble. Many of the products under the average American’s kitchen sink are created by companies owned by Procter & Gamble. A subsidiary is owned and controlled by a larger “parent” company.

When a subsidiary issues a bond, it can utilize the parent company as its “co-signer.” The parent company becomes responsible if the subsidiary cannot repay the borrowed funds. For example, if Pampers issues a guaranteed bond, Procter & Gamble could “guarantee” the bond by obligating itself to repay borrowed funds if Pampers cannot.

Although guaranteed bonds come with the parent company’s backing, they are considered unsecured bonds. Essentially, the bond’s success or failure depends on the parent company’s ability to pay off the bond. A bond must have collateral (a valuable asset) to be secured, and a promise to pay from another company doesn’t count as collateral.

Guaranteed bonds can also refer to bonds insured by third parties, which most commonly occurs with municipal (state and city government) bonds. For example, if the city of Denver issues a bond that is insured by Ambac (an insurance company), the bond is “guaranteed.”

Bottom line - any bond with backing from a third party is considered a guaranteed bond.

Income bonds

Income bonds, sometimes referred to as adjustment bonds, are risky debt securities that emerge from bankruptcy. Assume a corporation issues a bond but later defaults and cannot make required payments to its bondholders. When this occurs, the bondholders typically sue the issuer in bankruptcy court. The US bankruptcy court system 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 its assets, including real estate, equipment, and inventory. Once the company sells its assets, it returns as much money to its creditors (bondholders included) as possible. Payments are prioritized to specific parties as we learned in the common stock chapter and will be covered again in the next chapter.

If liquidation occurs, the corporation and its businesses are finished. But, what if the bondholders believe the bankrupt issuer may be able to reform and “rise from the ashes?” They can allow the corporation to restructure debt and issue income bonds to the affected bondholders. Before doing so, the corporation will first “destroy” the old bonds. Then, they issue new income bonds 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 its business. It makes interest payments to the income bondholders if the company is profitable again. The corporation may fix its problems, which would be a win-win for bondholders and the issuer. Unfortunately, most income bonds don’t turn out that way. When a company goes bankrupt and is allowed to restructure, it often doesn’t attain a profitable status again. Income bonds would never pay interest or principal if this were to occur. It’s relatively common for income bonds to become worthless, so they’re considered risky investments only the most aggressive investors should consider. These securities sell at very high yields (low prices) in the market.

If you encounter a recommendation-based (suitability) question on the exam, income bonds are almost always the wrong answer. Test writers know income bonds are tricky because of the ‘income’ in their name. To the untrained eye, they’re bonds that pay income when they most often don’t. Be aware of this trick!

Mortgage bonds

Mortgage bonds are the first type of secured (collateralized) bond we’ll discuss in detail. When a corporation issues a mortgage bond, it pledges real estate as collateral to its bondholders. Examples include factories, distribution centers, and office buildings.

Corporations issue mortgage bonds as a way to lower their overall cost of borrowing money. If an issuer sells debentures, investors take on more risk with no collateral and demand higher interest rates. The issuer can lower their interest cost (rate) by pledging real estate as collateral, but will lose it if they cannot pay off the bond.

Utility companies are common issuers of mortgage bonds. These organizations often own many valuable properties that can be used as collateral. There are several examples of utility companies issuing mortgage bonds backed by factories, electrical grids, and power plants:

• Xcel Energy issues $750 million in first mortgage bonds
• Commonwealth Edison issues $800 million in first mortgage bonds
• Consumers Energy issues $525 million in first mortgage bonds

All of the examples above refer to first mortgage bonds, which relate to priority if liquidation of the collateral occurs. Assume a mortgage bond issuer cannot make required payments to bondholders. In this case, the company must liquidate (sell) the real estate collateral backing the bond. First mortgage bondholders receive the sale proceeds first until they’re made whole. After, any excess proceeds are sent to second mortgage bond investors. Because they’re lower on the priority scale, second mortgage bonds are riskier, trade at lower prices in the market, and provide higher yields to their investors.

Equipment trust certificates (ETCs)

Equipment trust certificates (ETCs) are also secured (collateralized) bonds. If a corporation sells bonds backed by its equipment, it issues ETCs. Collateral could include vehicles, construction equipment, or airplanes. For example, Delta Airlines has issued ETCs by pledging their airplanes as collateral for decades.

ETCs are typically issued in serial format due to the depreciation of the equipment over time. To fully back an offering, the collateral must be worth at least the combined value of future interest and principal payments. Equipment depreciates (loses value) over time, so issuers of ETCs need to pay their debt down (pay off principal) over time. By having bonds mature at different intervals, the corporation can structure a bond offering in a way that aligns with the depreciation of the equipment.

Collateral trust certificates (CTCs)

Collateral trust certificates (CTCs) are bonds secured by marketable assets owned by the corporation. Types of marketable assets could include a portfolio of investments or a subsidiary.

For example, PepsiCo Inc. 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.