| GENERAL
DESCRIPTION
Corporate
bonds are debt obligations issued by corporations. Corporate bonds
may be either secured or unsecured. Collateral used for secured debt includes
but is not limited to real property, machinery, equipment, accounts receivable,
stocks, bonds, or notes. If the debt is unsecured, the bonds are known
as debentures Bondholders,
as creditors, have a prior legal claim over common and preferred stockholders
as to both income and assets of the corporation for the principal and
interest due them and may have a prior claim over other creditors if liens
or mortgages are involved. Corporate bonds contain elements of both interest-rate
risk and credit risk. Corporate bonds usually yield more than government
or agency bonds due to the presence of credit risk. Corporate bonds are
issued as registered bonds and are usually sold in
book-entry form. Interest may be fixed, floating, or the bonds may
be zero-coupons.
Interest on corporate bonds is typically paid semiannually and is fully
taxable to the bondholder.
CHARACTERISTICS
AND FEATURES
Security for Bonds
Various types of security may be pledged to offer security
beyond that of the general standing of the issuer. Secured bonds, such
as first-mortgage bonds, collateral trust bonds, and equipment trust certificates,
yield a lower rate of interest than comparable unsecured bonds because
of the greater security they provide to the bondholder.
First-Mortgage Bonds
First-mortgage bonds normally grant the bond holder a first-mortgage
lien on the property of the issuer. Often first-mortgage bonds are issued
in series with bonds of each series secured equally by the same first
mortgage.
Collateral Trust Bonds
Collateral trust bonds are secured by pledges of stocks,
notes, bonds, or other collateral. Generally, the market or appraised
value of the collateral must be maintained at some percentage of the amount
of the bonds outstanding, and a provision for withdrawal of some collateral
is often included, provided other acceptable collateral is provided. Collateral
trust bonds may be issued in series.
Equipment Trust Certificates
Equipment trust certificates are usually issued by railroads
or airlines. The issuer, such as a railroad company or airline, buys a
piece of equipment from a manufacturer, who transfers the title to the
equipment to a trustee. The trustee then leases the equipment to the issuer
and at the same time sells equipment trust certificates (ETCs) to investors.
The manufacturer is paid off through the sale of the certificates, and
interest and principal are paid to the bondholders through the proceeds
of lease payments from the issuer to the trustee. At the end of some specified
period of time, the certificates are paid off, the trustee sells the equipment
to the issuer for a nominal price, and the lease is terminated. As the
issuer does not own the equipment, foreclosing a lien in event of default
is facilitated. These bonds are often issued in serial form.
Debenture Bonds
Debenture bonds are not secured by a specific pledge of
designated property. Debenture bond-holders have the claim of general
creditors on all assets of the issuer not pledged specifically to secure
other debt. They also have a claim on pledged assets to the extent that
these assets have value greater than necessary to satisfy secured creditors.
Debentures often contain a variety of provisions designed to afford some degree
of protection to bondholders, including limitation on the amount
of additional debt issuance, minimum maintenance requirements on net workingcapital,
and limits on the payment of cash dividends by the issuer. If and issuer has no secured debt,
it is customary to provide a negative pledge clause-a provision that debentures will be secured
equally with any secured bonds that may be issued in the future.
Subordinated and Convertible Debentures
Subordinated debenture bonds stand behind secured debt,
debenture bonds, and often some general creditors in their claim on assets
and earnings. Because these bonds are weaker in their claim on assets,
they yield a higher rate of interest than comparable secured bonds. Often,
subordinated debenture bonds offer conversion privileges to convert bonds
into shares of an issuer's own common stock or the common stock of a corporation
other than an issuer- referred to as exchangeable bonds.
Guaranteed Bonds
Guaranteed bonds are guaranteed by a corporation other
than the issuer. The safety of a guaranteed bond depends on the financial
capability of the guarantor, as well as the financial capability of the
issuer. The terms of the guarantee may call for the guarantor to guarantee
the payment of interest and/or repayment of principal.
A guaranteed bond may have more than one corporate guarantor, who may
be responsible for not only its pro rata share but also the entire amount
guaranteed by other guarantors.
Maturity
Corporate bonds are issued in a broad
maturity spectrum, ranging from less than one year to perpetual issues.
Issues maturing within one year are usually viewed as the equivalent of
cash items. Debt maturing between one and five years is generally thought
of as short-term. Intermediate-term debt is usually considered to mature
between 5 and 12 years, whereas long-term debt matures in more than 12
years.
Interest-Payment Characteristics
Fixed-Rate Bonds
Most fixed-rate corporate bonds pay interest semiannually
and at maturity. Interest payments once a year are the norm for bonds
sold overseas. Interest on corporate bonds is based on a 360-day year,
made up of twelve 30-day months.
Zero-Coupon Bonds
Zero-coupon bonds are bonds without
coupons or a stated interest rate. These securities are issued at
discounts to par; the difference between the face amount and the offering
price when first issued is called the original-issue discount (OID). The
rate of return depends on the amount of the discount and the period over
which it accretes. In bankruptcy, a zero-coupon bond creditor can claim
the original offering price plus accrued and unpaid interest to the date
of bankruptcy filing, but not the principal amount of $1,000.
Floating-Rate Notes
The coupon rates for
floating-rate notes are based on various benchmarks ranging from short-term
rates, such as prime and 30-day
commercial paper, to one-year and longer constant maturity Treasury
rates (CMTs). Coupons are usually quoted as spread above or below the
base rate (that is, three-month LIBOR + 15 bp). The interest rate paid
on floating-rate notes adjusts based on changes in the base rate. For
example, a note linked to three-month U.S.
LIBOR would adjust every three months, based on the then prevailing
yield on three-month U.S. LIBOR. Floating-rate notes are often subject
to a maximum (cap) or minimum (floor) rate of interest.
Features
A significant portion of corporate notes and bonds has
various features. These include call provisions, in which the issuer has
the right to redeem the bond before maturity; put options, in which the
holder has the right to redeem the bond before maturity;
sinking funds, used to retire the bonds at maturity; and convertibility
features that allow the holder to exchange debt for equity in the issuing
company.
Callable Bonds
Callable
bonds are bonds in which the investor has sold a call option to the issuer.
This increases the coupon rate paid by the issuer but exposes the investor
to prepayment risk. If market interest rates fall below the coupon rate
of the bond on the call date, the issuer will call the bond and the investor
will be forced to invest the proceeds in a low-interest-rate environment.
As a rule, corporate bonds are callable at a premium above par, which
declines gradually as the bond approaches maturity.
Put Bonds
Put bonds are bonds in which the investor has purchased
a put option from the issuer. The cost of this put option decreases the
coupon rate paid by the issuer, but decreases the risk to an investor
in a rising interest-rate environment. If market rates are above the coupon
rate of the bond at the put date, the investor can "put" the bond back
to the issuer and reinvest the proceeds of the bond in a high-interest-rate
environment.
Sinking-Fund Provisions
Bonds with sinking-fund provisions require the issuer to
retire a specified portion on a bond issue each year. This type of provision
reduces the default risk on the bond because of the orderly retirement
of the issue before maturity. The investor assumes the risk, however,
that the bonds may be called at a special sinking-fund call price at a
time when interest rates are lower than rates prevailing at the time the
bond was issued. In that case, the bonds will be selling above par but
may be retired by the issuer at the special call price that may be equal
to par value.
Convertible Bonds
Convertible
securities are fixed income securities that permit the holder the
right to acquire, at the investor's option, the common stock of the issuing
corporation under terms set forth in the bond indenture. New convertible
issues typically have a maturity of 25 to 30 years and carry a coupon
rate below that of a nonconvertible bond of comparable quality. An investor
in a convertible security receives the upside potential of the common
stock of the issuer, combined with the safety of principal in terms of
a prior claim to assets over equity security holders. The investor, however,
pays for this conversion privilege by accepting a significantly lower
yield-to-maturity than that offered on comparable non-convertible bonds.
Also, if anticipated corporate growth is not realized, the investor sacrifices
current yield and risks having the price of the bond fall below the price
paid to acquire it. Commercial banks may purchase eligible convertible
issues if the yield obtained is reasonably similar to nonconvertible issues
of similar quality and maturity, and the issues are not selling at a significant
conversion premium.
USES
Corporate bonds can be used for hedging, investment, or speculative
purposes. In some instances, the presence of credit risk and lack of liquidity
in various issues may discourage their use. Speculators can use corporate
bonds to take positions on the level and term structure of both interest
rates and corporate spreads over government securities.
Banks often purchase corporate bonds for their investment portfolios.
In return for increased credit risk, corporate bonds provide an enhanced
spread relative to Treasury securities. Banks may purchase investment-grade
corporate securities subject to a 10 percent limitation of its capital
and surplus for one obligor. Banks are prohibited from underwriting
or dealing in these securities. A bank's section 20 subsidiary may, however,
be able to underwrite and deal in corporate bonds.
Banks often act as corporate trustees for bond issues. A corporate trustee
is responsible for authenticating the bonds issued and ensuring that the
issuer complies with all of the covenants specified in the indenture.
Corporate trustees are subject to the Trust Indenture Act, which specifies
that adequate requirements for the performance of the trustee's duties
on behalf of the bondholders be developed. Furthermore, the trustee's
interest as a trustee must not conflict with other interest it may have,
and the trustee must provide reports to bondholders.
DESCRIPTION
OF MARKETPLACE
.The size of the total corporate bond market was $2.2 trillion dollars
at the end of 1993. Nonfinancial corporate business comprised approximately
56 percent of total issuance in 1993
Market Participants
Buy Side
The largest holder of corporate debt in the United States is the insurance
industry, accounting for more than 33 percent of ownership at the end
of 1993. Private pension funds are the second largest holders with 13.7
percent of ownership. Commercial banks account for approximately 4.5 percent
of ownership of out-standing corporate bonds.
Sell Side
Corporate bonds are underwritten in the
primary market by investment banks and section 20 subsidiaries of
banks. In the secondary market, corporate bonds are traded in the listed
and unlisted markets. Listed markets include the New York Stock Exchange
and the American Stock Exchange. These markets primarily ser-vice retail
investors who trade in small lots. The over-the-counter market is the
primary market for professional investors. In the secondary market, investment
banks and section 20 subsidiaries of banks may act as either a broker
or dealer. Brokers
execute orders for the accounts of customers; they are agents and get
a commission for their services. Dealers
buy and sell for their own accounts, thus taking the risk of reselling
at a loss.
Sources of Information
For a primary offering, the primary source of information is contained
in a prospectus filed by the issuer with the Securities and Exchange Commission.
For seasoned issues, major contractual procisions are provided in
Moody's manuals or Standard
& Poor's corporation records.
Bond ratings are published by several organizations that analyze bonds
and express their conclusions by a ratings system. The four major nationally
recognized statistical rating organizations (NRSROs) in the United States
are Duff & Phelps Credit Rating Co. (D&P);
Fitch Investor Service, Inc. (Fitch); Moody's Investor Service, Inc.
(Moody's); and Standard & Poor's Corporation (S&P).
PRICING
The major factors influencing the value of a coporate bond are-
its coupon rate relative to prevailing market interest rates (typical
of all bonds, bond prices will decline when market interest rates rise
above the coupon rate, and prices will rise when interest rates decline
below the coupon rate) and
the issuer's credit standing (a change in an issuer's financial condition
or ability to finance the debt can cause a change in the risk premium
and price of the security).
Other factors that influence corporate bond prices are the existence
of call options, put features, sinking funds, convertibility features,
and guarantees or insurance. These factors can significantly alter the
risk/return profile of a bond issue.
The majority of corporate bonds are traded on the over-the-counter market
and are priced as a spread over U.S. Treasuries. Most often the benchmark
U.S. Treasury is the on-the-run (current coupon) issue. However, pricing
"abnormalities" can occur where the benchmark U.S. Treasury is different
from the on-the-run security.
HEDGING
Interest-rate risk for corporate debt can be hedged either with cash,
exchange-traded, or over-the-counter instruments. Typically, long corporate
bond or note positions are hedged by selling a U.S. Treasury issue of
similar maturity or by shorting an exchange-traded futures contract. The
effectiveness of the hedge depends, in part, on basis risk and the degree
to which the hedge has neutralized interest-rate risk. Hedging strategies
may incorporate assumptions about the correlation between the credit spread
and government rates. The effectiveness of these strategies may be affected
if these assumptions prove inaccurate. Hedges can be constructed with
securities from the identical issuer but with varying maturities. Alternatively,
hedges can be constructed with issuers within an industry group. The relative
illiquidity of various corporate instruments may diminish hedging effectiveness.
RISKS
Interest-Rate Risk
For fixed-income bonds, prices fluctuate with changes in interest rates.
The degree of interest-rate sensitivity depends on the maturity and coupon
of the bond. Floating-rate issues lessen the bank's interest-rate risk
to the extent that the rate adjustments are responsive to market rate
movements. For this reason, these issues generally have lower yields to
compensate for their benefit to the holder.
Prepayment or Reinvestment Risk
Call provisions will also affect a bank's interest-rate exposure. If
the issuer has the right to redeem the bond before maturity, the action
has the potential to adversely alter the investor's exposure. The issue
is most likely to be called when market rates have moved in the issuer's
favor, leaving the investor with funds to invest in a lower-interest-rate
environment.
Credit Risk
Credit risk is a function of the financial condition of the issuer or
the degree of support provided by a credit enhancement. The bond rating
may be a quick indicator of credit quality. However, changes in bond ratings
may lag changes in financial condition. Banks holding corporate bonds
should perform a periodic financial analysis to determine the credit quality
of the issuer.
Some bonds will include a credit enhancement in the form of insurance
or a guarantee by another corporation. The safety of the bond may depend
on the financial condition of the guarantor, since the guarantor will
make principal and interest payments if the obligor cannot. Credit enhancements
often are used to improve the credit rating of a bond issue, thereby reducing
the rate of interest that the issuer must pay.
Zero-coupon bonds may pose greater credit risk problems. When a zero-coupon
bond has been sold at a deep
discount, the issuer must have the funds to make a large payment at
maturity. This potentially large balloon repayment may significantly increase
the credit risk of the issue.
Liquidity Risk
Major issues are actively traded in large amounts, and liquidity concerns
may be small. Trading for many issues, however, may be inactive and significant
liquidity problems may affect pricing. The trading volume of a security
determines the size of the bid/ask spread of a bond. This provides an
indication of the bond's marketability and, hence its, liquidity. A narrow
spread of between one-quarter to one-half of one percent may indicate
a liquid market, while a spread of two or three percent may indicate poor
liquidity for a bond. Even for major issues, news of credit problems may
cause temporary liquidity problems.
Event Risk
Event risk can be large for corporate bonds. This is the risk of an unpredictable
event that immediately affects the ability of an issuer to service the
obligations of a bond. Examples of event risk include leveraged buyouts,
corporate restructurings, or court rulings that affect the credit rating
of a company. To mitigate event risk, some indentures include a maintenance
of net worth clause, which requires the issuer to maintain its net worth
above a stipulated level. If the requirement is not met, the issuer must
begin to retire its debt at par.
LEGAL LIMITATIONS FOR BANK INVESTMENT
Corporate notes and bonds are type III securities. A bank
may purchase or sell for its own account corporate debt subject to the
limitation that the corporate debt of a single obligor may not exceed
10 percent of the bank's capital and surplus. To be eligible for purchase,
a corporate security must be "investment grade" (that is, rated BBB-
or higher) and must be marketable. Banks may not deal in or underwrite
corporate bonds.
REFERENCES Fabozzi, Frank,
and T. Dessa, eds. The Hand-book of Fixed Income Securities. Chicago:
Irwin Professional Publishing, 1995. Fabozzi, Frank, and Richard Wilson.
Corporate Bonds. Frank J. Fabozzi Associates, 1996. "How Do Corporate
Spread Curves Move Over Time?" Salomon Brothers, July 1995.
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