Chapter 6: Corporate Bonds

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The Trust Indenture Act of 1939

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Liquidation Rights
- Wages
- Taxes
- Secured Creditors Including Secured Bonds
- General Creditors Including Debentures
- Subordinated Creditors including Subordinated Debentures
- Preferred Stockholder
- Common Stockholder

b. “New issues of corporate bonds must be registered under the Securities Act of 1933 and are subject to the Trust Indenture Act of 1939” (Note: muni bonds, government bonds, and other exempt securities are not subject to the Trust Indenture Act

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Closed-End Indenture

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does not permit the corporation to issue additional bonds secured by the same claim on the same assets as the original issues, thus providing the bondholder with the greatest protection since the security behind the bonds cannot be diluted.

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Open-End Indenture

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permits the corporation to issue additional bonds secured by the same assets as the original issue. If additional bonds are issued, the original bondholders’ protection is diluted. Therefore the indenture will usually require that the corporation meet a specific level of earnings before it is permitted to issue additional bonds. This is called the “earnings test” or “additional bonds test.”

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Secured Bonds

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bonds backed by the full faith and credit of the issuer and by specific assets that the corporation owns

- Mortgage Bonds
- Equipment Trust Certificates
- Collateral Trust Bonds

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Mortgage Bonds

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secured by a first or second mortgage on real proper, giving the bondholders a lien on the property

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Equipment Trust Certificates

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secured by a specific piece of equipment that is owned by the company and used in its business (i.e. transportation companies; railroad, airline, etc.)

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Collateral Trust Bonds

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secured by third-party securities (i.e. stocks or bonds) owned by the issuer. The securities are placed in escrow as collateral for the bonds.

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Unsecured Bonds

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referred to as “notes” and “debentures.” These corporate bonds are secured only by the corporation’s good faith and credit.

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Subordinated debentures

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unsecured bonds that have a junior claim on their assets compared to its outstanding unsecured bonds.

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Fallen Angels

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bonds that start out at investment-grade rating and then are lowered to below investment grade.

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Guaranteed Bonds

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a corporate bond that, in addition to its normal security, is secured by a guarantee of another corporation to pay interest and principal if necessary. A typical example would be a parent company guaranteeing a bond issued by a subsidiary company.

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Conversion Ratio

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Conversion Ratio = Par Value of Bond / Conversion Price

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Conversion Value

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the market value of the stock that the investor receives upon conversion. This determines whether or not it is worthwhile to convert the bond into stock.

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The effect of Stock Splits and Stock Dividends

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i. “If the stock splits or the corporation declares a stock dividend, then the conversion process and conversion ratio will be adjusted accordingly. This is sometimes known as the non-dilution feature or covenant.”

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Parity

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the convertible bond’s conversion value is equal to its market price

i. Most bonds trade a premium to parity, meaning that the market price of the bond is higher than the market value of the stock the investor would receive upon conversion.

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Advantages of Convertible Bonds

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i. Advantages
1. “Convertible bonds allow corporation to borrow money at a lower rate (lower coupon) because the convertible feature is attractive to investors
2. Convertible bonds give investors a greater degree of safety than preferred or common stock, but also give them the potential for capital appreciation if the underlying stock appreciates in value.
3. The investor has downside protection if the price of the stock falls because the convertible bond still has value as a bond.

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Disadvantages of Convertible Bonds

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1. If all bonds are converted into common stock, then the number of outstanding shares may increase dramatically. The stockholders equity will be diluted and the EPS will decrease. In order to reflect this possibility, a company’s EPS may be restated as fully diluted EPS, a figure that assumes all conversions have been made.
2. Forced Conversion: Most convertible issues are callable. As with nonconvertible bonds, the issuer may call in the bonds and redeem them at its option. However, the redemption price of the bonds may be less than the conversion value and the bondholder could be forced to either convert the bonds immediately or accept less than their conversion value.

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Arbitrage

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a technique that involves profiting from price differentials in the same or similar security. There are times when the market price of the convertible bond does not reflect the value of the common stock that would be received if the bond were converted into stock.

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Income Bonds (Adjustment Bonds)

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i. Normally issued by companies in reorganization (bankruptcy)
ii. The issuer promises to repay the principal amount at maturity but promises to pay interest only if it is has sufficient earnings. Since interest payments are not promised, income bonds trade flat (without accrued interest), sell at a deep discount (well below par), and are considered speculative.

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Eurodollar Bonds

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i. Dollar-denominated deposit outside the United States.
ii. Pay principal and interest in U.S. dollars and are issued outside the U.S. (primarily in Europe)
iii. Examples: corporations, foreign governments, and international agencies
iv. The bonds are not registered with the U.S. Securities and Exchange Commission and consequently may not be sold in the United States until 40 or 90 days after they are issued.

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Yankee Bonds

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i. Allow foreign entities to borrow money in the U.S. marketplace.
ii. They are registered with the SEC and sold primarily in the United States.

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Eurobonds

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i. Sold in one country and denominated in the currency of another.
ii. The issuer, currency, and primary market can all be different (e.g. Russian mayonnaise manufacturer could sell bonds denominated in Swiss Francs in London)

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NYSE Nine-Bond Rule

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For orders of nine bonds ($9,000 par value) or less, members must check the market on the floor of the Exchange and fill any order there if prices are equal to or better than the price in the OTC market. However, an order for nine bonds or less may be executed in the OTC market if the customer specifically makes such a request.

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Yellow Sheets

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published weekly by the National Quotation Bureau. Show bid and asks quotations for the corporate bonds traded in the OTC markets.