What are corporate bonds?
Corporate bonds are issued by corporations and usually mature within 1 to 30 years. These bonds usually offer a higher yield than government bonds but carry more risk. Corporate bonds can be categorized into groups, depending on the market sector the company operates in. They can also be differentiated based on the security backing the bond or the lack of security.
Quick Summary Points
- Corporate bonds are issued by corporations and usually distributed by a trustee such as a bank
- Corporate bonds are split into five categories: public utilities, transportation, industrials, banks and finance companies, and international issues
- Bonds can be backed by a variety of assets, such as mortgages, equipment, or other companies
How are corporate bonds distributed?
Corporate bonds are usually sold through a third party, called the corporate trustee. Having a third party helps solve a number of issues. For example, it might be difficult for investors to understand covenants and determine if companies are keeping in line with the contract details. By having a knowledgable third party, investors can rely on the trustee to manage the relationship with the corporations.
Corporate trustees can be a bank or trust company that authenticate the bonds and keep track of them when they are sold. If a corporate issuer defaults on interest or principal payments, then the trustee is responsible for taking actions to protect the rights of the bondholder. However, trustees are paid by the debt issuer and can only do what the contract provides. Therefore, the trustee might not be allowed to make certain investigations into the corporation and often has to rely on opinions that the corporation provides.
Types of corporate bonds
There are five basic categories of corporate bonds: public utilities, transportations, industrials, banks and finance companies, and international issues. The five categories can be further broken down. For example, the transportation category includes airlines, railroads, and trucking companies.
Security of bonds
Security for bonds suggests some kind of underlying asset that backs up the issue. This is preferable for investors, as it provides risk protection against a potential corporate default. Assets backing the bond provide security beyond the credit of the issuer.
Bonds can be backed by different assets. For example, bonds that are backed by mortgages are mortgage-backed securities (MBS). A mortgage bond gives the bondholders the ability to sell mortgaged properties to satisfy any unpaid obligations to bondholders.
Collateral trust bonds
Collateral trust bonds are similar to mortgage bonds except houses are not used to back up the bond. These are used by companies that do not own fixed assets or real property. Instead, these companies own securities of other companies. When issuing bonds, they pledge such stocks, bonds, or other investments that they own in other companies.
Equipment trust certificates
Equipment trust certificates usually revolve around the rental of equipment. For example, assume a railway company needs some cars and orders them from a manufacturer. The manufacturer will complete the order and transfer the ownership of the cars to a trustee. The trustee will then sell equipment trust certificates to investors to pay the manufacturer for the cars. To continue to pay interest on the ETCs, the trustee collects rental fees from the railway company. Upon maturity of the note, the railway company then receives the titles to the cars from the trustee.
The renting of the railway cars is not a true leasing arrangement, due to the fact that the railway company will get title to the cars at the end of the ETC agreement. Thus, in essence, equipment trust certificates are a type of secured debt financing.
Debenture bonds are unsecured bonds that are not backed by, for example, designated properties or other assets. In the category of government bonds, Treasury bills are an example of a debenture bond. Debenture bonds are usually issued by corporations with strong credit ratings and, therefore, do not typically offer very high interest rates. Corporations that have already issued mortgage bonds or collateral bonds can also offer debenture bonds. The debenture bonds issued in such cases are considered to be of lower quality.
Debenture bonds may be convertible – that is, bondholders have the option of converting the bonds into a specified number of shares of the company’s stock after a specified point in time (for example, after two years). Convertible bonds are generally more attractive to investors and, therefore, typically pay lower coupon rates.
As the name suggests, guaranteed bonds are bonds that are guaranteed. The guarantee is provided by another corporation. This helps decrease the default risk, as another corporation has agreed to step in and fulfill the covenants of the bond if the need arises. However, this does not make the bond totally free of default risk, as the corporation that guarantees the bond might be unable to fulfill its guarantee contract.
High yield corporate bonds
High yield bonds, or junk bonds, are rated below investment grade by rating agencies. The term suggests that the bond is higher risk but does not mean the corporation which issued the bonds will default or is subject to bankruptcy. High yield bonds fall into three types of issuers: original issuers, fallen angels, and restructurings and leveraged buyouts.
Original issuers are newer companies that do not have strong balance sheets or income statements. They sell bonds based on promises of future growth and profitability. Fallen angels are companies that have investment-grade debt. However, these companies faced issues over the years that led to deterioration of their credit rating. Restructuring and leveraged buyouts are companies have voluntarily increased debt burden in order to maximize shareholder value. The new bonds these corporations issue are considered junk bonds due to the already high debt burden of the company.
Default rates of corporate bonds
The default rate is the likelihood an issuer does not pay the coupon rate or principal. The first way to calculate the default rate is to divide the number of issuers that defaulted by the total number of issuers at the beginning of the year. The second way is to take the dollar amount of bonds that have defaulted and divide it by the total par value of all bonds outstanding. During the 25 years between 1970 to 1994, 640 out of 4,800 corporate issuers, only 0.13%, defaulted on a bond. It is important to note that “default” also includes corporations that missed payments or delayed payments.
Due to the way default payment is calculated, it is important to take into account recovery rates. This is because investors often recover payments that were missed or were late. The recovery rate for corporate bonds is around 38%.
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