There are two main sectors in the economy: public and private sectors.The private sector consists of profit and non-profit businesses.The non-profit is just a very minor compare to the profit part of the private sector and rarely issuing bonds to finance its operation.Therefore,this article will mainly focus on bonds issued by for-profit companies.Generally,when a company needs money to finance its business it raises capital by issuing stocks and/or bonds;when it needs a short term cash,like money to improve cash flow,it issues commercial papers or simply a bank loan or credit line.Thus,companies usually issue bonds for its long term need of fund and a corporate bond is a legal debt contract which obligates the corporation to pay periodic interest and repay the principal at maturity to the bondholders.
Corporate bonds can be classified into secured and unsecured bonds.Secured bonds are debts backed by tangible assets such as real estate or equipments.Unsecured bonds are debts simply backed by the corporation’s promise to pay.For this nature most unsecured bonds are rated speculative by rating companies.
Secured bonds are termed depending on the source which is pledged as collateral for the issue.If real estate is pledged then the bond is termed as mortgage bond,if equipments are pledged then it is termed “Equipment Trust Certificate”,if marketable securities are pledged then it is termed “Collateral Trust Certificate.”
Secured bonds are highly rated because the bondholders have the lien on the pledged assets;that is,if the corporation defaults or bankrupts,bondholders have a legal right to sell those assets to get back their money.
The real estate used to collateral mortgage bonds may include land and associated proved reserves,buildings and physical infrastructure,factory.Mortgage bonds may divided into senior or junior lien status.When a corporation issues mortgage bonds the first time it is called senior mortgage bonds and when it issues bonds of the same asset back the second and third times these bonds are called junior mortgage bonds.Senior bonds are paid first if pledged assets are liquidated; so,they are rated higher than junior.
Unsecured bonds commonly termed as “debenture” are non-collateral debts.They are not always rated junk,some large strong companies also issue debentures which are highly rated due to the company’s high credit rating.Like senior and junior status in mortgage bonds,debentures of secondary offerings are termed subordinated debentures and have a lower status of claim in an asset liquidation.
To attract more buyers debentures usually have a conversion feature in the contracts that the bonds may convert into the corporation’s common stocks at a specified conversion ratio and time,then the bonds are termed convertible bonds.
Guaranteed bonds: unsecured bonds issued by a subsidiary company can be guaranteed by its parent company and then it takes on the credit rating of its parent.The parent company will guarantee the payments of interest and principal in case its subsidiary fails.This way they can save their financing cost.
Adjustment bonds or income bonds: when a company went bankrupt it might have negotiated with its bondholders for not liquidating the pledged assets in exchange for its reorganization and emergence.The bond contract is adjusted (so it calls adjustment bonds) and obligates the emerging company to service its debts when
it operates normally.Usually,the principal will be adjusted higher and the interests are accumulated and will be paid when the company started to be profitable.
Trading: Corporate bonds are mostly traded over the counter.The bond market is thin and much less active than stocks that leads to ill liquidity,large bid and ask spreads,slow quotes,and high commissions.It is not wise to trade single bond frequently like stocks or currencies.Individuals want to invest in corporate bonds can access through other investment vehicles like an appropriate bond mutual fund or a closed-end bond fund.
Taxation: Interest income and capital gain from corporate bonds are subject to both Federal and State Tax.The 15% cap is not applied like dividend income from stocks,interest income may be taxed up to 35%.Because of the bond characteristics taxing issues for bonds are more complicated than for stocks.For example,a zero-coupon bonds of $1,000 par value pay no interest but offer price at $750 lower than par,the $250 difference between the acquiring price and par will be treated as interest income and accreted over the life,say 5 years, of the bond.Each year $50 is taxed as interest income,then this $50 will be added to $750 cost; until maturity the cost is $1,000 equal to redemption value and resulting no capital gain.For this reason most corporate bonds are held in taxed-deferred accounts like IRA.