Bond Types

What are Corporate Bonds?

A corporate bond is a bond issued by major corporations and can be divided into five major groups: industrials, transportations, utilities, banks and other finance companies, and finally international. Bonds issued from the industrial sector would include manufacturing, mining, and retail oriented companies. Transportation bonds would then be issued by airlines, trucking companies, and even railroads. Utilities would include companies which would fall into the following groups; water, electric, and telephone. International bonds would be issued by foreign entities such as foreign countries, municipalities, and agencies.

Event Risk

Corporate bonds are like no other in that they have an implied event risk. Takeovers, corporate restructuring, and even LBO's can have dramatic consequences to a bonds credit rating and even price. Unless you were acting on inside information, it was nearly impossible to predict these dramatic shifts in a company and therefore; corporate bond issuers were forced to provide additional bond features to remove some of the uncertainty associated with corporate bonds.

What are Convertible Bonds?

A convertible bond is a security, typically ranging between 25 and 30 years in term, that gives its' owner the right to acquire the issuers common stock directly from the issuer rather than purchasing it in the open market. The terms under which this exchange can occur are detailed out in the bond indenture. The optionality component of this security, which allows for the bond holder to convert debt into equity, results in the bond holder receiving lower yields as compared to non-convertible securities.

Typically, convertible bonds will be classified as subordinated debt and therefore more risky than unsubordinated debt. Subordinated debt holders are lower on the totem pole as far as principal repayment during times of distress for the issuer. In the event of bankruptcy, "senior" bond holders will be paid their credit balance before subordinated debt holders.

Convertible Bond Structure

A convertible bond has a few key additional features in structure as compared to a typical bond:

What is Commercial Paper?

A corporation may issue bonds or equity to fulfill their long term capital needs; however, corporations are also in need of short term funds as well. As an alternative to bank borrowing, corporations may issue commercial paper which are basically short term, unsecured notes issued in the open market for immediate financing needs. The majority of commercial paper issuances are done through large corporations with solid credit ratings; however, in more recent history we have seen corporations with lower credit worthiness entering the marketplace. These corporations with sub-par credit quality will obtain credit support from a firm with a higher credit rating than themselves. This support is usually in the form of a "letter of credit" which is a guarantee by the supporting corporation that the debt will be repaid if the issuer defaults. The bank charges the issuer a fee for this and in turn the issuer has access to capital markets it otherwise wouldn't have access to.

Callable Bond: Definition

A callable bond, or redeemable bond, gives the bond issuer the right to purchase the bond back from the bond holder before the maturity date of the bond.  Issuers will compensate the bond holder with an option premium to allow themselves the opportunity to purchase the bond back if they are paying the bond holder a higher coupon than the market bears.

Upon calling a bond, the issuer will then resell the bond back onto the open market with a lower coupon consistent with current market conditions.

What are High Yield Bonds?

Once considered a risky proposition, the market for high yield bonds has grown to a large, yet stable market for availing capital to noninvestment-grade companies who do not meet the credit rating guidelines established by S&P, Moody's, and Fitch.

During the LBO explosion in the 1980's, many non-traditional financing vehicles were set in place to handle short-term borrowing needs; however, in recent years, the market has stabilized and gone back to the basic borrowing vehicles. These are plain vanilla cash-pay, fixed rate debt. There are still situations that require more non-traditional lending practices but these are not seen as readily as they were in the past. They are primarily used to finance high growth industries that have high funding needs and longer term revenue generating streams.

Let's cover some of the basic types of debt securities issued in the high yield bond market.