Corporate Bonds

Moving from government-backed securities to the private sector, corporate bonds introduce credit risk - the possibility that the issuer may not pay you back.

Corporate Bond Basics

• Issued by corporations to raise capital (debt financing, as opposed to issuing stock)
• Pay semiannual interest (coupon) and return principal at maturity
• Standard par value: $1,000
• Subject to credit (default) risk - the issuer may fail to pay interest or principal
• Fully taxable at federal, state, and local levels

Exam Tip: Gotchas

• Corporate bond interest is taxable at ALL levels (federal, state, and local). This is the opposite of municipal bonds, which are exempt from federal tax.

Types of Corporate Bonds by Security

Corporate bonds range from the most secured to the most speculative. The level of backing determines priority in liquidation and the yield investors demand:

Liquidation priority (who gets paid first if the company goes bankrupt):

1. Secured bondholders (first claim on specific assets)
2. Unsecured bondholders (debenture holders)
3. Subordinated debenture holders
4. Preferred stockholders
5. Common stockholders (last in line)

Think of it this way: The more security a bondholder has, the less they need to worry about getting paid back. Secured bondholders have specific assets backing their claim, so they accept a lower yield. Unsecured bondholders rely only on the company's promise, so they demand higher yields to compensate for the extra risk.

Exam Tip: Gotchas

• Debentures are UNSECURED. The word sounds technical, but it simply means "no collateral." They rely only on the issuer's creditworthiness.
• Subordinated means LOWER priority in liquidation (paid after regular debentures). Lower priority = higher yield to compensate.

Zero-Coupon Corporate Bonds

• Purchased at a deep discount to par value
• No periodic interest payments - the investor's return is the difference between purchase price and par
• Investor receives full par value ($1,000) at maturity
• Subject to phantom income taxation; the IRS taxes the annual accretion of the discount even though no cash is received
• Have higher interest rate risk than coupon bonds because there is no reinvestment income to offset price changes

Why does this matter for taxes? Even though you receive no cash until maturity, the IRS treats the annual increase in the bond's value (from discount toward par) as taxable income each year. You owe taxes on money you have not actually received yet.

Exam Tip: Gotchas

• Zero-coupon bonds have the HIGHEST interest rate risk among coupon-bearing alternatives. With no periodic income to reinvest at higher rates, price is the only source of return, making it fully exposed to rate changes.

Convertible Bonds

• Give the bondholder the right to convert the bond into a specified number of common stock shares
• Offer lower coupon rates than comparable non-convertible bonds (the conversion privilege has value)
• Conversion ratio = par value / conversion price
• Investors benefit if the stock price rises above the conversion price
• Provide downside protection (bond floor) with equity upside potential

Example: A $1,000 bond with a conversion price of $50:

• Conversion ratio = $1,000 / $50 = 20 shares
• If the stock trades at $60, conversion value = 20 x $60 = $1,200 (conversion is attractive)

Exam Tip: Gotchas

• Convertible bonds have LOWER yields than comparable non-convertible bonds. The conversion feature has value, so investors accept a lower coupon in exchange for equity upside.

High-Yield (Junk) Bonds

• Rated below investment grade (BB/Ba or lower by rating agencies)
• Offer higher coupon rates to compensate investors for greater credit risk
• Greater default risk than investment-grade bonds
• May be issued by companies with weaker financial profiles or those undergoing restructuring
• "High-yield" and "junk" refer to the same category of bonds