Personal Investment Management
ADMS 3531 Fall 2011 – Professor Dale Domian
Lecture 10 Part 1 – Corporate Bonds – Nov 22
Chapter 18 Outline
Corporate bond basics.
Types of corporate bonds.
Bonds without indentures.
Adjustablerate bonds and adjustablerate preferred stock.
Corporate bond ratings.
Bond market trading.
Corporate Bond Basics
A corporate bond is a security issued by a corporation.
It represents a promise to pay bondholders a fixed sum of money (called the bond’s
principal, or par or face value) at a future maturity date, along with periodic payments of
interest (called coupons).
Corporate bonds differ from common stock in three fundamental ways.
Corporate Bonds Common Stock
Represent a creditor’s claim on the Represents an ownership claim on the
Promised cash flows (coupons and Amount and timing of dividends may
principal) are stated in advance. change at any time.
Mostly callable. Almost never callable.
In Canada, the corporate bond market is illiquid; however there are several trillion dollars
of corporate bonds outstanding in the United States.
More than half of these are owned by life insurance companies and pension funds.
o These institutions can eliminate much of their financial risk via cash flow
matching. o They can also diversify away most default risk by including a large number of
different bond issues in their portfolios.
Types of Corporate Bonds
Bonds issued with a standard, relatively simple set of features are popularly called Plain
Vanilla Bonds (or ‘bullet’ bonds).
o Debentures are unsecured bonds issued by a corporation.
o Mortgage bonds are debt secured with a property lien.
o Collateral trust bonds are debt secured with financial collateral.
o Equipment trust certificates are shares in a trust with income from a lease
A bond indenture is a formal written agreement between the corporation and the
This agreement spells out, in detail, the obligations of the corporation, the rights of the
corporation, and the rights of the bondholders (with respect to the bond issue).
In practice, few bond investors read the original indenture. Instead, they might refer to an
indenture summary provided in the prospectus of the bond issue.
Different bond issues can usually be differentiated according to the seniority of their
claims on the firm’s assets in case of default.
o Senior debentures are the bonds paid first in case of default.
o Subordinated debentures are paid after senior debentures.
Bond seniority may be protected by a negative pledge clause.
A negative pledge clause prohibits a new debt issue that would have seniority over
A call provision allows the issuer to buy back all or part of its outstanding bonds at a
specified call price sometime before the bonds mature.
When interest rates fall, bond prices increase.
o The corporation can ‘callin’ the existing bonds, i.e. pay the call price.
o The corporation can then issue new bonds with a lower coupon.
o The process is called bond refunding.
Bond Indentures, MakeWhole Call Provisions Makewhole call provisions have recently become common.
Like a fixedprice call provision, a makewhole call provision allows the issuer to pay off
the remaining debt early. However,
o The issuer must pay the bondholders a price equal to the present value of all
As interest rates decrease:
o The makewhole call price increases.
o But, even in the region of low yields, these bonds still exhibit the standard convex
priceyield relationship in all yield regions.
A bond with a put provision can be sold back to the issuer at a prespecified price
(normally set at par value) on any of a sequence of prespecified dates.
Bonds with put provisions are often called extendible bonds.
BondtoStock Conversion Provisions
Convertible bonds are bonds that can be exchanged for common stock according to a pre
specified conversion ratio (i.e., the number of shares acquired).
Bond Maturity Provisions
Bond maturity and principal payment provisions – term bonds are issued with a single
maturity date, while serial bonds are issued with a regular sequence of maturity dates.
Term bonds normally have a sinking fund, which is an account used to repay some
bondholders before maturity.
Money paid into a sinking fund can only be used to pay bondholders.
Some bondholders are repaid before the stated maturity