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

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

Investment-Grade vs. 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

S&P / Fitch Rating Ladder (highest to lowest)

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.

Yield Spreads and 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.

Convertible Bonds

• 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.

Zero-Coupon Bonds

• 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.

Secured (Mortgage) Bonds

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

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

Sinking Fund Provisions

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

Bondholders cannot convert their bonds under a sinking fund. Sinking fund retirement is at the issuer's option.

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.

Corporate Bond Types Summary

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."

Exam Tip: Gotchas

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