Corporate Bonds

The rest of this lesson breaks bonds down by rating (investment-grade versus junk), by feature (convertible, zero-coupon, sinking fund), and by legal priority. Each distinction shows up as its own exam question type.

What Are Corporate Bonds?

Corporations issue bonds to raise debt capital. Corporate bonds pay semiannual fixed interest (coupon) and return principal at maturity.

• Standard par value: $1,000
• Subject to credit (default) risk - issuer may fail to pay interest or principal
• Interest is taxable at all levels (federal, state, local)
• Rated by Moody's, Standard & Poor's (S&P), and Fitch for credit quality
• Bonds are negotiable instruments; their negotiability allows them to be transferred or sold to another investor in the secondary market before maturity

What Is the Indenture?

The indenture is the formal written contract between the issuer and the bondholders. It is sometimes called the trust agreement or deed of trust. The indenture spells out:

• Coupon rate, payment dates, maturity
• Collateral (if any) backing the bond
• Call provisions, sinking fund provisions, conversion features
• Covenants the issuer must meet (financial ratios, restrictions on additional debt)
• The trustee who represents bondholder interests

What Separates Investment-Grade from High-Yield Bonds?

• Investment-grade bonds: Rated BBB- (S&P) or Baa3 (Moody's) or higher; lower yield; lower default risk
• High-yield (junk) bonds: Rated below BBB-/Baa3; higher yield; higher default risk; typically issued by lower-rated or financially weaker companies

What Is the S&P/Fitch Rating Ladder?

S&P and Fitch use + and - modifiers (AA+, AA, AA-) within each category; Moody's uses 1, 2, 3 (Aa1, Aa2, Aa3). The + or 1 indicates the highest tier within the category.

Exam Tip: Gotchas

• The BBB-/Baa3 line separates investment-grade from junk. Worth remembering.
• Ratings measure credit (default) risk only; they do not measure liquidity, interest-rate risk, or suitability for any particular investor.

How Do Yield Spreads Move With Economic Stress?

The yield spread is the extra yield a high-yield (junk) bond pays over a comparable Treasury. During periods of economic stress, spreads widen significantly as investors demand more compensation for default risk and rotate away from credit. In healthy economies, spreads narrow.

How Do Convertible Bonds Work?

• Can be converted into a fixed number of shares of the issuer's common stock
• Offer a lower coupon than comparable non-convertible bonds because the conversion feature has value
• Give investors equity upside while still receiving bond interest payments
• If the stock price rises above the conversion price, the bondholder can convert and profit

Exam Tip: Gotchas

• Convertible bonds pay lower coupons than non-convertible bonds. The conversion privilege compensates for the lower interest.

How Do Zero-Coupon Bonds Work?

• Pay no periodic interest; issued at a deep discount to par value
• The difference between purchase price and par value represents the investor's return
• Phantom income: Even though the investor receives no cash until maturity, the IRS requires annual tax on accrued interest (the "accretion" of the discount)
• Popular in tax-deferred accounts (like IRAs) where phantom income is not an issue

Exam Tip: Gotchas

• Zero-coupon bond holders owe taxes every year on phantom income even though they receive no cash until maturity.

What Are Secured (Mortgage) Bonds?

• Backed by specific assets (real estate, equipment)
• Highest priority among bonds in liquidation

What Are the Types of Unsecured Bonds?

• Debenture: Backed only by issuer's general creditworthiness (unsecured); below secured bonds in liquidation
• Subordinated Debenture: Unsecured and junior to regular debentures; still senior to stockholders
• Income (adjustment) bonds: Pay interest only if the issuer earns sufficient income; lowest priority among bonds

What Is a Sinking Fund Provision?

A sinking fund is a provision in the bond indenture that requires the issuer to set aside money periodically to retire portions of the debt before maturity. This reduces the issuer's repayment burden at maturity and lowers the bond's credit risk.

The issuer can retire bonds under the sinking fund by:

• Calling bonds at par (a sinking fund call, typically without premium)
• Purchasing bonds in the open market if they trade below par
• Lottery selection among outstanding bonds

Lottery selection means the issuer is retiring only part of the issue, so specific bond certificates or positions are selected from the outstanding bonds. For the investor, the practical point is that a selected bond is paid off early, usually at par under the sinking fund terms, while unselected bonds remain outstanding.

Bondholders cannot convert their bonds under a sinking fund. The indenture's sinking-fund schedule requires the issuer to retire part of the issue; the issuer only chooses the retirement method (calling, open-market purchase, or lottery), not whether retirement happens at all.

Exam Tip: Gotchas

• A sinking fund benefits investors by lowering credit risk and providing some price support, but it also caps upside: bonds called at par cannot continue to appreciate above par.
• Investors may face reinvestment risk when their bonds are called early under a sinking fund.

How Do the Bond Types Compare?

What Is the Liquidation Priority, Most Senior to Most Junior?

Key Rule: Debt always comes before equity, regardless of descriptive words. A "junior subordinated debenture" still beats a "senior preferred stock." Income bonds, the lowest-priority bond type, rank below subordinated debentures but still ahead of preferred and common stock, since debt always beats equity.

Exam Tip: Gotchas

• "Senior preferred stock" never comes before subordinated debt. All debt beats all equity, period.

What Should You Check on Exam Day?

• Standard corporate bond par is $1,000; interest is taxable at all levels
• Investment-grade floor is BBB-/Baa3; below that is high-yield (junk)
• Convertible bonds pay lower coupons because the conversion feature has value
• Zero-coupon bonds create phantom income taxed annually despite no cash received
• Liquidation order: secured, then unsecured debentures, then subordinated debentures, then income bonds, then preferred stock, then common stock
• A sinking fund lowers credit risk but caps upside because bonds get called at par