Understanding Corporate Bond Structures and Classifications
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Repayment: Long-term debt is typically repaid in regular amounts over the life of the debt. The payment of long-term debt by installments is called amortization(usually arranged by a sinking fund. Each year the corporation places money into a sinking fund, and the money is used to buy back the bonds).
Seniority: indicates preference in position over other lenders. Some debt issubordinated.In the event of default, holders of subordinated debt must give preference other specified creditors who are paid first.
Security: it’s a form of attachment to property. It provides that the property can be sold in event of default to satisfy the debt for which the security is given. A mortgage is used for security in tangible property. Debentures are not secured by a mortgage.
Bond Indenture:contract between the company and the bondholders that includes:
- The total amount of bonds issued
- A description of property used as security, if applicable
- Sinking fund provisions
- Call provisions
- Details of protective covenants
Bond Classifications:
- Registered vs. Bearer Forms
- Security
oCollateral – secured by financial securities
oMortgage – secured by real property, normally land or buildings
oNotes – unsecured debt with original maturity less than 10 years
- Seniority
Required yields:The coupon rate depends on the risk characteristics of the bond when issued.
- Make no periodic interest payments (coupon rate = 0%)
- The entire yield to maturity comes from the difference between the purchase price and the par value
- Cannot sell for more than par value
- Sometimes called zeroes, deep discount bonds, or original issue discount bonds (OIDs)- Treasury Bills and principal-only Treasury strips are good examples of zeroes
1. Pure discount bonds
2.Floating rate bonds: Coupon rate floats depending on some index value. Ex: adjustable rate mortgages and inflation-linked Treasuries. There is less price risk with floating rate bonds (The coupon floats, so it is less likely to differ substantially from the yield to maturity). Coupons may have a “collar” – the rate cannot go above a specified “ceiling” or below a specified “floor”.
- Other bond types:- Income bonds- Convertible bonds- Put bonds
- There are many other types of provisions that can be added to a bond, and many bonds have
- several provisions – it is important to recognize how these provisions affect required returns.