Now that you understand bond fundamentals, let's explore the different types of corporate bonds. The key distinction is whether a bond is backed by collateral (secured) or only by the issuer's promise to pay (unsecured).
Secured Bonds (Backed by Collateral)
Secured bonds are backed by specific assets that the bondholder can claim if the issuer defaults. They have higher priority in bankruptcy than unsecured bonds.
| Type | Collateral | Key Feature |
|---|---|---|
| Mortgage bond | Real property (land, buildings) | Lien on specific real estate; first mortgage bonds have senior claim |
| Equipment trust certificate (ETC) | Physical equipment (aircraft, railroad cars) | Title held by trustee; commonly issued by airlines and railroads |
| Collateral trust bond | Securities (stocks/bonds of other companies) | Pledged financial assets held by trustee |
Equipment trust certificates deserve special attention:
- Among the safest corporate bonds because the underlying equipment has resale value
- The trustee holds legal title to the equipment until maturity
- Protected under U.S. Bankruptcy Code provisions for aircraft and railroad rolling stock that exempt the equipment from the automatic stay in bankruptcy
- Typically use a serial maturity structure where outstanding principal decreases over time as the equipment depreciates
Exam Tip: Gotchas
- Equipment trust certificates are among the safest corporate bonds (not the riskiest). The underlying equipment has resale value and is protected from the automatic stay in bankruptcy.
Unsecured Bonds (Debentures)
Debentures are backed only by the issuer's general creditworthiness and ability to pay. No specific collateral is pledged.
- Debenture: Backed only by the issuer's general credit; no specific collateral
- Subordinated debenture: Ranks below senior debentures and all secured debt in bankruptcy; higher yield to compensate
- Debentures are the most common type of corporate bond
- In liquidation, the priority of claims (highest to lowest):
- Secured bondholders
- Senior unsecured (debentures)
- Subordinated debentures
- Preferred stockholders
- Common stockholders
Exam Tip: Gotchas
- "Debenture" does NOT mean risky. It simply means unsecured. A debenture from a AAA-rated company may be safer than a secured bond from a lower-rated issuer.
- Subordinated debentures rank below ALL other bondholders but still above preferred and common stockholders in liquidation.
Income Bonds (Adjustment Bonds)
Income bonds are a special category issued by companies in financial distress:
- Pay interest only if the issuer earns sufficient income
- Issued by companies in financial distress or emerging from bankruptcy reorganization
- Failure to pay interest is not an event of default (unlike other bonds)
- Trade flat (without accrued interest) because interest payments are not guaranteed
Exam Tip: Gotchas
- Income bonds do not default when they skip interest payments. Unlike other bonds, failure to pay interest is not an event of default.
- Bonds that trade "flat" do not include accrued interest in the price. Income bonds and bonds in default trade flat.
Zero-Coupon Bonds
Zero-coupon bonds pay no periodic interest. The investor's entire return comes from the difference between the deeply discounted purchase price and par value at maturity.
- Issued at a deep discount to par (e.g., buy at $600, receive $1,000 at maturity)
- No periodic coupon payments: the $400 discount is the investor's return
- Greatest interest rate risk of any bond type because all cash flow occurs at maturity (longest duration)
- No reinvestment risk because there are no coupons to reinvest
- Phantom income: The annual accretion of the original issue discount (OID) is taxed each year even though no cash is received
Think of it this way: You buy a zero-coupon bond at $600 and it matures at $1,000. The IRS treats that $400 gain as if it accrues a little each year, and you owe tax on each year's portion even though you receive no cash until maturity. That is why zero-coupon bonds work best in tax-deferred accounts like IRAs.
Zero-coupon bond summary:
- Coupon payments: None
- Purchase price: Deep discount to par
- Interest rate risk: Highest (maximum price volatility)
- Reinvestment risk: None (no coupons to reinvest)
- Tax treatment: Annual phantom income (OID accretion)
- Best suited for: Tax-deferred accounts (IRAs, 401(k)s)
Exam Tip: Gotchas
- Zero-coupon bonds have NO reinvestment risk (no coupons to reinvest) but MAXIMUM interest rate risk (highest price volatility).
- Phantom income is taxable annually even though you receive no cash. This makes zero-coupon bonds best suited for tax-deferred accounts.
Step-Coupon Bonds (Step-Up Bonds)
Step-coupon bonds have a coupon rate that increases at predetermined intervals according to the indenture.
- May reset once (single-step) or multiple times (multi-step)
- Often callable on each step-up date; the issuer can redeem rather than pay the higher rate
- Provide a hedge against rising interest rates for investors
- Offer a higher weighted average coupon than comparable fixed-rate bonds
Exam Tip: Gotchas
- Step-coupon bonds are often callable on step-up dates. The issuer is likely to call the bond rather than pay the higher rate, so investors may not receive the full benefit of later step-ups.
High-Yield Bonds (Junk Bonds)
High-yield bonds are rated below investment grade:
- Below BBB- (S&P/Fitch) or below Baa3 (Moody's)
- Offer higher coupon rates to compensate for greater default risk
- Often issued by companies with high leverage, limited operating history, or in financial distress
- Subject to wider price swings based on changes in the issuer's creditworthiness
- Greater credit risk but potentially higher returns
Exam Tip: Gotchas
- High-yield does not mean high-quality. "High-yield" and "junk" are the same thing: bonds rated below investment grade (below BBB-/Baa3). The higher coupon compensates for greater default risk.