We’ll now look at several types of long-term corporate debt, typically with maturities ranging from 3 to 40 years. When a corporate issuer can use borrowed funds for an extended period, the debt is considered funded.
A debenture is a long-term, unsecured (naked) corporate bond. Debentures are riskier than secured corporate bonds because there’s no pledged collateral.
The issuer is still legally obligated to repay the borrowed funds, but if the corporation goes bankrupt, bondholders don’t have a specific asset they can claim. Because investors take on more risk, debentures are typically issued with higher coupons and trade at higher yields (lower prices) than similar secured corporate bonds.
In the securities industry, you’ll usually avoid the word guarantee because investors are never guaranteed to make money. However, guaranteed bonds do exist. To understand them, you first need the idea of a subsidiary.
As companies grow, they often become compartmentalized. For example, Crest Toothpaste, Head & Shoulders, and Pampers are subsidiaries of Procter & Gamble. A subsidiary is owned and controlled by a larger parent company.
When a subsidiary issues a bond, the parent company can act like a “co-signer.” If the subsidiary can’t repay the borrowed funds, the parent company becomes responsible. For example, if Pampers issues a guaranteed bond, Procter & Gamble could guarantee it by obligating itself to repay the borrowed funds if Pampers can’t.
Even with the parent company’s backing, guaranteed bonds are considered unsecured bonds. A bond is secured only when it has pledged collateral (a valuable asset). A third party’s promise to pay isn’t collateral.
The term guaranteed bond can also refer to bonds insured by third parties, most commonly 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 considered “guaranteed.”
Bottom line: any bond with backing from a third party is considered a guaranteed bond.
Income bonds, sometimes called adjustment bonds, are risky debt securities that typically emerge from bankruptcy.
Suppose a corporation issues bonds but later defaults and can’t make the required payments. Bondholders may sue the issuer in bankruptcy court. The US bankruptcy court system is complicated, but the basic idea is straightforward: bondholders generally push for one of two outcomes:
If bondholders don’t believe the business will ever become successful again, they’ll seek liquidation. Liquidation means the company sells its assets (real estate, equipment, inventory, and so on) and returns as much money as possible to creditors, including bondholders. Payments follow a legal priority order, as introduced in the common stock chapter and covered again in the next chapter.
Liquidation ends the corporation and its businesses. But if bondholders believe the issuer might recover, they may allow the corporation to restructure debt. In a restructuring, the corporation typically cancels (“destroys”) the old bonds and issues new income bonds to the affected bondholders.
Income bonds only pay interest if the company has sufficient earnings. The new bonds may also have different features, interest rates, and par values than the original failed bonds.
After bankruptcy court, the issuer returns to operating its business. If the company becomes profitable again, it makes interest payments to income bondholders. In many cases, though, companies that restructure don’t return to profitability. If that happens, income bonds may never pay interest or principal. It’s relatively common for income bonds to become worthless, which is why they’re considered high-risk investments suitable only for the most aggressive investors. In the market, these securities sell at very high yields (low prices).
If you see a recommendation-based (suitability) question on the exam, income bonds are almost always the wrong answer. Test writers often use the word “income” to mislead - these bonds frequently don’t pay income.
Mortgage bonds are the first type of secured (collateralized) bond we’ll cover in detail. When a corporation issues a mortgage bond, it pledges real estate as collateral for the bondholders. Examples include factories, distribution centers, and office buildings.
Corporations issue mortgage bonds to reduce their overall borrowing cost. With debentures, investors have no collateral and typically demand higher interest rates. By pledging real estate, the issuer can often borrow at a lower interest rate - but it risks losing the property if it can’t repay the bond.
Utility companies commonly issue mortgage bonds because they often own large amounts of valuable property that can be pledged as collateral. These bonds may be backed by factories, electrical grids, and power plants.
First mortgage bonds and second mortgage bonds describe priority if the collateral must be liquidated. If the issuer can’t repay interest and principal, the company may be forced to sell the real estate collateral.
Because second mortgage bonds have lower priority, they’re riskier, trade at lower prices, and offer higher yields.
Equipment trust certificates (ETCs) are also secured (collateralized) bonds. When a corporation issues bonds backed by its equipment, it issues ETCs. The collateral might 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 because equipment depreciates over time. To fully back the offering, the collateral must be worth at least the combined value of future interest and principal payments. Since the equipment’s value declines, issuers often need to pay down principal over time.
By structuring maturities at different intervals, the issuer can align principal repayment with the equipment’s depreciation.
Collateral trust certificates (CTCs) are bonds secured by marketable assets owned by the corporation. These marketable assets might include a portfolio of investments or a subsidiary.
For example, PepsiCo Inc. could issue a bond and pledge Gatorade (a subsidiary of theirs) as 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 repay bondholders.
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