Corporate Bonds

The whole unit on one sheet: bond mechanics, the bond types, ratings, taxes, money-market instruments, and the yield ladder the exam loves.

Bond Fundamentals

• Par (face) value is $1,000 per bond; coupon is the stated annual rate; interest pays semiannually unless stated otherwise.
• Quotation is a percentage of par: 98.50 = $985.00, 102 = $1,020.00.
• The bond indenture (trust indenture) is the legal contract; a trustee enforces its terms for bondholders.
• Callable bonds let the issuer redeem early (issuer calls when rates fall to refinance) and pay higher coupons to compensate for call risk. A make-whole call pays the present value of remaining cash flows, effectively removing the incentive to call early.

Types of Corporate Bonds

• Secured (higher priority in bankruptcy): mortgage bonds (real property), equipment trust certificates (equipment; among the safest corporate bonds), collateral trust bonds (pledged securities).
• Unsecured (debentures): backed only by general credit; the most common corporate bond. Subordinated debentures rank below senior debentures and all secured debt.
• Liquidation priority: secured bondholders, senior unsecured (debentures), subordinated debentures, preferred stockholders, common stockholders.
• Income (adjustment) bonds: pay interest only if the issuer earns enough; skipping interest is not a default; trade flat.
• Zero-coupon: deep discount to par, no coupons, maximum interest rate risk, no reinvestment risk, annual phantom income.
• Step-coupon (step-up): coupon rises at set intervals; often callable on each step-up date.
• High-yield (junk): rated below investment grade; higher coupon for greater default risk.

Convertible Bonds

• Convert into a fixed number of common shares at the bondholder's option; pay a lower coupon because the conversion feature has value.
• Conversion ratio = Par Value / Conversion Price (fixed at issuance; adjusts only for stock splits or stock dividends).
• Parity price of the stock = Bond Market Price / Conversion Ratio. Parity price of the bond = Stock Market Price x Conversion Ratio.
• Investment value (straight-bond value) is a price floor.
• Forced conversion: the issuer calls the bond; if conversion value tops the call price, a rational holder converts.

The One-Liners That Win Points

• "Debenture" means unsecured, not risky; a debenture from a top-rated company can beat a secured bond from a weak one.
• Equipment trust certificates are among the safest corporate bonds, not the riskiest.
• Convertible bonds pay lower coupons; conversion is the holder's choice, not the issuer's.
• Bond ratings measure default (credit) risk only, never interest rate, market, liquidity, or reinvestment risk.
• Investment grade bottoms out at BBB-/Baa3; one notch lower is junk.
• Zero-coupon bonds carry maximum interest rate risk and zero reinvestment risk.
• Original issue discount (OID) accretion raises cost basis; premium amortization lowers it.
• Commercial paper is unsecured and caps at 270 days to stay exempt from registration.
• "Eurodollar" means outside the currency's home country, not the euro.

Numbers to Lock In

Bond Ratings

• The "Big Three": Standard & Poor's (S&P), Moody's, and Fitch.
• Modifiers: S&P and Fitch use +/-; Moody's uses 1/2/3.
• Investment grade: BBB-/Baa3 or higher. Speculative (junk): BB+/Ba1 or below.
• Higher rating = lower yield. A downgrade drops price and lifts yield; an upgrade does the reverse.
• Fallen angel: an investment-grade bond downgraded to junk; institutions restricted to investment grade are forced to sell, deepening the price drop.

Tax Treatment of Taxable Debt

• Coupon interest is taxed as ordinary income at the federal, state, and local level.
• OID = Par Value - Original Issue Price, accreted annually and taxed as ordinary income (phantom income); basis rises to par, so no gain or loss at maturity.
• Premium (bought above par) may be amortized to lower cost basis; amortization is optional on corporate bonds.
• Market discount (bought below par in the secondary market) is taxed as ordinary income at sale or maturity, not capital gain.

Money-Market and Structured Products

• Commercial paper: short-term unsecured note, 1 to 270 days, sold at a discount, exempt from registration at 270 days or less.
• Brokered CDs: FDIC insured to $250,000; trade in the secondary market; may be callable; face interest rate risk if sold early.
• Eurodollar bonds: dollar-denominated, issued outside the U.S., pay interest annually, not registered.
• Equity-linked notes: debt with returns tied to an equity benchmark; principal protection (if any) does not remove issuer credit risk; upside may be capped.
• Exchange-traded notes (ETNs): unsecured debt of the issuer, no underlying portfolio, zero tracking error, subject to issuer credit risk (unlike ETFs).

Types of Yields

• Coupon (nominal) yield = Annual Coupon / Par Value (fixed).
• Current yield = Annual Coupon / Current Market Price (income only).
• Yield to maturity (YTM): total return if held to maturity; most comprehensive for non-callable bonds.
• Yield to call (YTC): total return to the first call date; use for callable premium bonds.
• Yield to worst: the lowest of YTM and all YTCs; equals YTC for a premium callable bond, YTM for a discount callable bond.
• Premium bond: Coupon > Current > YTM > YTC. Discount bond: Coupon < Current < YTM < YTC. Par bond: all equal.

Memory Aid: Discount Climbs, Premium Dips

For a discount bond, each yield measure climbs higher (Nominal, Current, YTM, YTC). For a premium bond, each measure dips lower in the same order. Par sits flat (all four equal).

Top Gotchas

• Prices are quoted as a percentage of par, so convert fast: 98.50 = $985.00, 102 = $1,020.00.
• Interest rate risk and reinvestment risk move in opposite directions.
• For a callable premium bond, use yield to worst, which equals YTC.
• Income bonds do not default when they skip interest, and they trade flat.
• Phantom income on zeros and OID bonds is taxable annually even with no cash received, so zeros fit tax-deferred accounts.
• Market discount at maturity is ordinary income, not capital gain.
• FDIC insurance on a brokered CD covers bank default only; selling early can still lose money to rate changes.
• Yankee bonds are SEC-registered and sold in the U.S.; Eurodollar bonds are not registered and sold outside the U.S. Both remove currency risk for U.S. investors.
• ETNs carry issuer credit risk; ETFs do not, because ETFs hold actual securities.

One-Breath Recap

Every corporate bond starts at $1,000 par, pays semiannual interest, and is quoted as a percentage of par, with secured debt outranking debentures in bankruptcy and investment grade stopping at BBB-/Baa3. Convertibles trade off a lower coupon for the holder's option to swap into stock, taxes turn on discount versus premium, and the yield ladder climbs on discount bonds and dips on premium bonds. Lock the numbers and the yield order and this unit answers itself.

Need more than the recap? This is a condensed summary. If it is not enough, read the full Corporate Bonds unit for the complete lesson.