Smart Bond Investing—Types of Bonds

Corporate Bonds

 

Companies issue corporate bonds (or corporates) to raise money for capital expenditures, operations and acquisitions. Corporates are issued by all types of businesses, and are segmented into major industry groups.

 

Corporate bondholders receive the equivalent of an IOU from the issuer of the bond. But unlike equity stockholders, the bondholder doesn't receive any ownership rights in the corporation. However, in the event that the corporation falls into bankruptcy and is liquidated, bondholders are more likely than common stockholders to receive some of their investment back.

 

There are many types of corporate bonds, and investors have a wide-range of choices with respect to bond structures, coupon rates, maturity dates and credit quality, among other characteristics. Most corporate bonds are issued with maturities ranging from one to 30 years (short-term debt that matures in 270 days or less is called "commercial paper"). Bondholders generally receive regular, predetermined interest payments (the "coupon"), set when the bond is issued. Interest payments are subject to federal and state income taxes, and capital gains and losses on the sale of corporate bonds are taxed at the same short- and longterm rates (for bonds held for less, or for more, than one year) that apply when an investor sells stock.

 

Most corporate bonds trade in the over-the-counter (OTC) market. The OTC market for corporates is decentralized, with bond dealers and brokers trading with each other around the country over the phone or electronically.

 

TRACE®Corporate Bond Trade Reporting Comes of Age

TRACE (the Trade Reporting and Compliance Engine®) was launched in 2002 to bring transparency to the corporate bond market and create a regulatory database of corporate bond information. TRACE enables individual investors to receive real-time information on the actual sale price of virtually all U.S. corporate bonds and to see intra-day transaction data, as well as aggregate end-of-day statistics (such as most active bonds, total volume, advances and declines and new highs and lows). All broker-dealers that FINRA regulates are required to report corporate bond transactions to the TRACE system.

Go to the TRACE Corporate Bond Data page for a snapshot of TRACE-reported corporate bond information.

 

Types of Corporate Bonds

 

There are two concepts that are important to understand with respect to corporate bonds. The first is that there are classifications of bonds based on a bond's relationship to a corporation's capital structure. This is important because where a bond structure ranks in terms of its claim on a company's assets determines which investors get paid first in the event a company has trouble meeting its financial obligations.

 

Secured Corporates

 

In this ranking structure, so-called senior secured debt is at the top of the list (senior refers to its place on the payout totem pole, not the age of the debt). Secured corporate bonds are backed by collateral that the issuer may sell to repay you if the bond defaults before, or at, maturity. For example, a bond might be backed by a specific factory or piece of industrial equipment.

 

Junior or Subordinated Bonds

 

Next on the payout hierarchy is unsecured debt—debt not secured by collateral, such as unsecured bonds. Unsecured bonds, called debentures, are backed only by the promise and good credit of the bond's issuer. Within unsecured debt is a category called subordinated debt—this is debt that gets paid only after higher-ranking debt gets paid. The more junior bonds issued by a company typically are referred to as subordinated debt, because a junior bondholder's claim for repayment of the principal of such bonds is subordinated to the claims of bondholders holding the issuer's more senior debt.

 

Who Gets Paid First?

1. Secured (collateralized) bondholders

2. Unsecured bondholders

3. Holders of subordinated debt

4. Preferred stockholders

5. Common stockholders

 

However, other types of claims also may have priority over the issuer's remaining assets over the claims of all bondholders (e.g., certain supplier or customer claims). Therefore, although bondholders generally are paid prior to stockholders in a bankruptcy proceeding, this may offer little comfort if the issuer's assets are reduced to zero by other creditors that have the right to be paid before bondholders of a particular class of bonds.

 

Investment and Non-Investment Grade Corporates

 

Corporate bonds tend to be categorized as either investment grade or non-investment grade. Non-investment grade bonds are also referred to as "high yield" bonds because they tend to pay higher yields than Treasuries and investment-grade corporate bonds. However, with this higher yield comes a higher level of risk. High yield bonds also go by another name: junk bonds.

 

Some corporate bonds are more liquid than others. Credit rating, yield and a host of other factors play on supply and demand. While you may not have trouble finding a buyer for the bond of a giant company, the ability to find a buyer for a low-grade, infrequently traded bond issued by a small company that few have heard about may be quite difficult (reflected in a much wider bid-ask spread).

 

Guaranteed and Insured Bonds

 

Certain bonds may be referred to as guaranteed or insured. This means that a third party has agreed to make the bond's interest and principal payments, when due, if the issuer is unable to make these payments. You should keep in mind that such guarantees are only as valuable as the creditworthiness of the third-party making the guarantee or providing the insurance.

 

Convertibles

 

Convertible bonds offer holders the income of regular bonds and also an option to convert into shares of common stock of the same issuer at a pre-established price, even if the market price of the stock is higher. Convertible bond prices are influenced most by the current price—and the perceived prospects of the future price—of the underlying stock into which they are convertible. As a tradeoff for this conversion privilege, convertible bonds typically yield less.

 

 

Corporate Bond Risk Report Card

  Green Checkmark Credit and default risk: Varies significantly from bond to bond and is sometimes hard to determine.
  Green Checkmark Liquidity risk: Many corporate bonds are illiquid, making it hard to find a buyer if you need to sell your bond.
  Green Checkmark Interest rate risk: If interest rates rise, the value of a corporate bond on the secondary market will likely fall.
  Green Checkmark Event risk: Mergers, acquisitions and other tumultuous events can have a negative impact on a bond issuer's ability to pay its creditors.

 

 

Corporate Securities Snapshot

  Issuer Corporate entity
  Minimum Investment Generally $1,000
  Interest Payment Fixed, floating/variable and zero-coupon. Interest is paid semiannually for fixed-coupon security.
  How to Buy/Sell Through a broker
  Bond Interest Rate Determined at origination, varies by bond
  Price Information FINRA Market Data—Bonds
  Website for More Info FINRA Market Data—Bonds

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