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About Corporate Bonds

Understanding Collateralization

In the event a corporation goes out of business or defaults on its debt, bondholders, as creditors, have priority over stockholders in bankruptcy court. However, the order of priority among all the vying groups of creditors depends on the specific terms of each bond, among other factors.

One of the most important factors is whether the bond is secured or unsecured. If a bond is secured, the issuer has pledged specific assets (known as collateral) that can be sold, if necessary, to pay the bondholders. If you buy a secured bond, you will “pay” for the extra safety by receiving a lower interest rate than you would have received on a comparable unsecured bond.

Debenture bonds

Most corporate bonds are debentures—that is, unsecured debt obligations backed only by the issuer’s general credit and the capacity of its cash flow to repay interest and principal. However, even unsecured bonds usually have the protection of what is known as a negative pledge provision. This requires the issuer to provide security for the unsecured bonds in the event that it subsequently pledges its assets to secure other debt obligations.

Credit ratings (discussed under Understanding Credit Risk,) are a tool for the investor who wants to know how strong a company’s unsecured bonds are.

Mortgage bonds

These are bonds for which real estate or other physical property has been pledged as collateral. They are mostly issued by public utilities.

There are various kinds of mortgage bonds, including the following: first, prior, overlying, junior, second, third and so on. The designation reflects the priority of the lien, or legal claim, you have against the specified property. Any time you invest in mortgage bonds, you should find out how much other debt of the issuer is secured by the same collateral and whether the lien supporting that other debt is equal or prior to your bond’s lien.

Collateral trust bonds

A corporation may deposit stocks, bonds and other securities with a trustee to back its bonds. The collateral must have a market value at the time of issuance at least equal to the value of the bonds.

Equipment trust certificates

Railroads and airlines have issued this type of bond as a way to pay for new equipment at relatively low interest rates. The title to the equipment is held by a trustee until the loan is paid off, and the investors who buy the certificates usually have a first claim on the equipment.

Subordinated debentures

Debt that is subordinated, or junior, has a priority lower than that of other debt in terms of payment (but like all bonds, it ranks ahead of stock). Only after secured bonds and debentures are paid off can holders of subordinated debentures be paid. In exchange for this lower status in the event of bankruptcy, investors in subordinated securities earn a higher rate of interest than is paid on senior securities.

Guaranteed bonds

Another form of security is a guarantee of one corporation’s bonds by another corporation. For example, bonds issued by a subsidiary may be guaranteed by the parent corporation. Or bonds issued by a joint venture between two companies may be guaranteed by both parent corporations. Guaranteed bonds become, in effect, debentures of the guaranteeing corporation and benefit from its presumably better credit.

 

All information and opinions contained in this publication were produced by the Securities Industry and Financial Markets Association from our membership and other sources believed by the Association to be accurate and reliable. By providing this general information, the Securities Industry and Financial Markets Association makes neither a recommendation as to the appropriateness of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and sources may be required to make informed investment decisions.