What are corporate bonds?
Corporate bonds are issued by corporations and usually matures 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 sector. They can also be differentiated base on the security that is backing it 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 up 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 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 the ones that were sold. If a corporate issuer default 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 investigations into the corporation and has to rely on certification and opinions that the corporation provides.
Types of corporate bonds
There are five 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, for the transportation category, it includes airlines, railroads, and trucking companies.
Security of bonds
Security for bonds suggests some kind of underlying asset that can back up the issue. This is preferable by investors as it provides backing in case the corporation defaults. Extra asset backing the bond provides security beyond the credit of the issuer.
Bonds can be backed by different assets. For example, bonds that are backed by mortgages are mortgage bonds. A mortgage bond gives the bondholders the ability to sell mortgaged properties to satisfy unpaid obligations to bondholders.
Collateral trust bonds
Collateral trust bonds are similar to mortgage bonds except houses is not used to back up the bond. This is 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 stocks, bonds or other obligations they own of other company.
Equipment trust certificates
Equipment trust certificates usually revolve around the rental of equipment. For example, a railway company needs some cars and orders it 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 pay off the manufacturer. To continue to pay interest on the ETCs, the trustee collects rental fees from the railway company. After the trustee pays off all of the ETCs, they will then sell the equipment to the railway company.
Debenture bonds are unsecured bonds that are not backed by designated properties. However, if the corporation does default, the owners of debenture bonds can claim any assets that have not been pledged yet. Debenture bonds are usually issued by corporations with strong credit ratings and does not offer higher interest rates. However, corporations that have already issued mortgage bonds or collateral bonds can also offer debenture bonds. The debenture bonds issued by these corporations are of lower quality.
Subordinated and convertible debentures
Subordinated means lower in rank and owners of a subordinated bond is last in among creditors to claim assets of a corporation. Since subordinated bonds have a weak claim on assets, it offers higher yields and gives an opportunity for owners to convert the bond into stock.
As the name suggests, guaranteed bonds are bonds that are guaranteed by another corporation. This helps decrease the default risk as another corporation will step in and fulfill the covenants of the bond. However, this does not make the bond free of default risk, as the corporation that guarantees the bond might be unable to fulfill the contract of the bond.
High yield corporate bonds
High yield bonds, or junk bonds, are rated below investment grade by rating agencies. This 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, which are 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 base 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. Restructuring and leveraged buyouts are companies have voluntarily increased debt burden in order to maximize shareholder value. The new bonds these corporation issues 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 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 issuers, or 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% and is not related to the size of the bond issuance.
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