Corporate Debt

Secured debt

A secured bond pledges specific assets as collateral. If the issuer defaults, bondholders have a claim on those assets ahead of general creditors.

Mortgage bonds are secured by real property — plant, land, buildings. They are the classic secured corporate bond and are common among utilities, whose assets are large, immovable and easy to value. An open-end mortgage bond permits the issuer to issue further bonds against the same property on an equal footing, which weakens existing holders; a closed-end mortgage bond does not, which strengthens them. When a question compares two otherwise identical mortgage bonds, closed-end is the safer one.

Equipment trust certificates are secured by rolling stock and other movable equipment — aircraft, railcars, truck fleets. Title to the equipment is held by a trustee until the certificates are paid. They are used almost exclusively by transportation companies, and their credit quality benefits from the fact that the collateral is standardized and readily resold.

Collateral trust bonds are secured by securities the issuer owns — commonly the stock or bonds of a subsidiary — deposited with a trustee. A holding company with no operating assets of its own uses this structure because the securities of its operating subsidiaries are the only collateral it has.

Unsecured debt and the special cases

A debenture is an unsecured bond backed only by the general credit and earning power of the issuer. Nothing is pledged. Debenture holders rank as general creditors — ahead of every class of equity, behind every secured claim. Most corporate bonds issued by large, creditworthy companies are debentures, which is why 'unsecured' is not a synonym for 'risky.'

Subordinated debentures rank behind other unsecured debt of the same issuer, which is why they carry higher yields. In a liquidation, the sequence within the corporate capital structure runs: secured bondholders, then general creditors including straight debenture holders, then subordinated debenture holders, then preferred shareholders, then common shareholders.

Guaranteed bonds are guaranteed as to interest, principal, or both by a party other than the issuer — most often a parent company standing behind a subsidiary's debt. The guarantee is only as good as the guarantor, which is the exam's point.

Income bonds, also called adjustment bonds, pay interest only if the issuer has sufficient earnings and the board declares it. They typically arise out of a reorganization, and they trade flat because there is no accrued interest to speak of. They are the most speculative form of corporate debt and are never suitable for an income-oriented customer — a question that pairs an income bond with a retiree seeking reliable income is testing exactly that.

Zero-coupon bonds pay no periodic interest and are issued at a deep discount to par. Step-coupon bonds start with a low coupon that rises on a stated schedule. Convertible bonds carry the equity conversion privilege covered in lesson 2.3, and pay a lower coupon in exchange for it.

High-yield bonds — rated below Baa3 or BBB- — pay more because default probability is materially higher, and their prices correlate more with equity markets and the business cycle than with interest rates. Suitability language matters here: 'high yield' and 'junk' describe the same instrument, and a representative who uses only the flattering name in a discussion with a customer has a problem.

Sinking funds, calls and covenants

A sinking fund provision requires the issuer to set aside money each year toward retiring the issue, usually by buying bonds in the open market or by calling a portion of them at a stated price. It reduces credit risk, because the debt is being extinguished progressively rather than sitting as a single large obligation at maturity, so a sinking fund issue yields less than an otherwise identical one without. It also introduces the possibility that a particular holder's bonds are called early, selected by lot.

Call provisions let the issuer redeem before maturity, usually at a premium that declines over time toward par, and usually after a period of call protection. As lesson 3.2 established, calls happen when rates fall, which is the worst moment for a holder. A make-whole call, common in modern corporate issues, requires the issuer to pay a price computed from the present value of the remaining payments, which largely removes the holder's disadvantage.

A put or tender option runs the other way: the holder may require the issuer to repurchase at a stated price on stated dates. It protects against rising rates and is therefore worth paying for, so a putable bond yields less than a comparable straight bond.

Protective covenants are the promises in the indenture. Affirmative covenants require the issuer to do things — maintain insurance, keep the collateral in repair, meet a stated interest coverage ratio, deliver audited financial statements. Negative covenants prohibit things — issuing additional debt of equal or higher priority beyond a limit, selling the pledged assets, paying dividends above a threshold. Covenants are what convert an unsecured promise into an enforceable one, which is why the trustee's job under the Trust Indenture Act is to monitor them.

Taxation of corporate debt

Interest on a corporate bond is fully taxable as ordinary income at federal, state and local level. This is the baseline against which municipal and Treasury taxation are contrasted, so fix it now: corporate interest is taxable everywhere.

Market discount — buying a bond in the secondary market below par — produces a gain at maturity that is generally treated as ordinary interest income to the extent of the accrued market discount, not as a capital gain. Selling before maturity at a profit produces a capital gain measured against the adjusted basis.

Original issue discount, the discount built in at issuance, is treated very differently. The discount is amortized and accreted into income annually over the bond's life, and the holder pays tax on that accretion each year even though no cash has been received — the phantom income problem. Each year's accretion raises the holder's cost basis, so that a zero-coupon bond held to maturity produces no additional gain at redemption. The practical consequence for a representative: a corporate zero-coupon bond is generally best held inside a tax-deferred account, because outside one it creates a tax liability with no cash to pay it. A Treasury zero has the same problem at federal level; a municipal zero does not, because its accretion is tax-exempt interest.

A bond bought at a premium may be amortized, reducing basis over the remaining life. For a taxable bond, amortization of premium is elective and produces an offset against interest income. For a municipal bond, amortization is mandatory, a point Module 4 returns to.