Corporate Bonds

Corporate bonds are debt securities issued by companies to raise capital. Understanding the different types of corporate bonds and their risk characteristics is essential for Series 7 representatives making suitable recommendations.

Secured vs. Unsecured Bonds

The key distinction among corporate bonds is whether they are backed by collateral.

Secured Bonds

Secured bonds are backed by specific assets that bondholders can claim if the issuer defaults. Because of this collateral backing, secured bonds are considered less risky and typically offer lower yields than unsecured bonds.

Equipment Trust Certificates (ETCs) are common in transportation industries. The trustee holds title to the equipment until the bonds are fully paid. This structure provides strong bondholder protection.

Unsecured Bonds (Debentures)

Debentures are unsecured bonds backed only by the issuer's creditworthiness and full faith and credit—not by any specific collateral.

Key Point: The term "debenture" specifically means unsecured. On the exam, "debenture" and "unsecured bond" are interchangeable.

Because there's no collateral, debentures carry higher risk and typically offer higher yields than secured bonds.

Subordinated Debentures

Subordinated debentures rank below regular debentures in the event of liquidation. These "junior" bonds are paid only after senior unsecured creditors are satisfied.

Risk hierarchy: Higher subordination = higher risk = higher required yield

Liquidation Priority

In bankruptcy, claims are paid in this order:

1. Secured creditors (collateralized bond holders)
2. Unsecured creditors (debenture holders)
3. Subordinated debt holders
4. Preferred stockholders
5. Common stockholders (last)

Exam tip: Bondholders always rank ahead of stockholders, but the type of bond determines the bondholder's relative position.

Convertible Bonds

Convertible bonds can be exchanged for a predetermined number of common shares at the bondholder's option.

Key Terms

Example: A $1,000 convertible bond with a 25:1 conversion ratio:

• Conversion price = $1,000 ÷ 25 = $40 per share
• If stock trades at $50, conversion value = 25 × $50 = $1,250

Convertible Bond Characteristics

Advantages for investors:

• Downside protection (bond floor provides income)
• Upside potential (participate in stock appreciation)
• Lower volatility than common stock

Trade-off: Convertible bonds typically offer lower coupon rates than non-convertible bonds because of the conversion privilege.

Anti-dilution provisions protect bondholders by adjusting the conversion ratio for stock splits and dividends.

High-Yield (Junk) Bonds

High-yield bonds (also called junk bonds or speculative-grade bonds) are rated below investment grade (BB+/Ba1 or lower).

High-Yield Bond Characteristics

• Higher yields compensate for increased default risk
• Greater price volatility than investment-grade bonds
• Correlation with stocks during market stress
• Often issued by smaller companies, leveraged buyouts, or struggling firms

Credit Ratings

Credit ratings assess the likelihood that a bond issuer will meet its obligations. The two major rating agencies are:

Rating Agency Comparison

Investment Grade vs. Speculative Grade

Investment grade (BBB-/Baa3 and above):

• Many institutional investors are restricted to investment-grade bonds
• Lower yields, lower default risk
• More stable prices

Speculative grade (BB+/Ba1 and below):

• Higher yields compensate for higher risk
• Subject to greater price volatility
• May be excluded from conservative portfolios

On the Exam

The Series 7 exam frequently tests:

• Distinguishing secured vs. unsecured bonds (especially debentures)
• Liquidation priority in bankruptcy
• Convertible bond calculations (conversion ratio, parity)
• Credit rating categories (investment grade vs. junk)