Corporate Bond

A corporate bond is a debt security issued by a company to raise money. The SEC describes the arrangement plainly: corporate bonds "are debt obligations of the issuer," where "the company promises to return the face value of the bond, also known as principal, on a specified maturity date," and "until that date, the company usually pays you a stated rate of interest, generally semiannually." Owning one gives no ownership interest in the company, which is the difference from owning its stock.

What separates a corporate bond from a government bond is not the mechanics, which are the same, but the fact that the promise can fail. A company can stop paying. That possibility has a price, and the price is visible: it is the difference between what this bond yields and what a government bond of the same maturity yields, commonly called the spread. When the spread widens, the market has decided the promise is worth less; when it narrows, the market has decided the opposite. A buyer choosing a corporate bond over a Treasury bond of the same length is accepting that judgment and being paid the spread for it.

Bondholders outrank stockholders, and they do not all outrank each other equally. The familiar ordering is that in a liquidation, bondholders are paid before preferred and common stockholders, and the SEC states it that way. What that ordering leaves out is the ranking among bondholders, which is what actually decides how much any particular holder recovers. A secured bond is backed by specific collateral, so its holders have a claim on identified assets. A senior unsecured bond, often called a debenture, ranks ahead of subordinated claims but is backed only by the company's general credit. A subordinated bond is contractually behind the senior claims, and its holders are paid only after those are satisfied. The SEC's own definition of a senior bond makes the point: it is "a bond that has a higher priority than another bond's claim to the same class of assets in case of a default or bankruptcy." Two bonds from the same company, maturing on the same day, can yield very differently for this reason alone, and the yield difference is not a bargain.

Callability is a corporate-bond problem more than a government one, and its asymmetry is the part to understand. A callable bond gives the issuer the right to repay it early. The SEC defines them as bonds "that can be redeemed or paid off by the issuer prior to the bond's maturity date." The issuer will exercise that right when it is good for the issuer, which means when interest rates have fallen and it can borrow more cheaply. So the holder is handed their money back at exactly the moment the income cannot be replaced at the same rate. If rates rise instead, nothing is called: the holder simply keeps a below-market bond for its full term. The upside is capped and the downside is not, and the extra yield a callable bond offers is payment for accepting that shape.

The tax treatment completes a three-way set worth holding in mind together. Interest on a corporate bond is taxable federally and by the state, if the holder's state taxes income. Interest on a Treasury security is taxable federally and exempt from state and local income tax. Interest on a municipal bond is generally exempt federally, with its state treatment depending on the holder's state and the issuer's. So the three instruments occupy the three useful positions, and comparing their headline yields without adjusting for that compares numbers that mean different things. The comparison that answers the question is what each leaves in the buyer's hands after tax, at that particular buyer's rate.

Credit quality is graded, and the grade is an opinion rather than a guarantee. Rating agencies assign letter grades, and the market divides the scale broadly into investment grade and high yield, the latter still widely called junk. The grade is a rating agency's assessment of the probability of being paid, it changes as circumstances change, and a downgrade of a bond already held reduces its price without anything having yet gone wrong. The detail of the scales and where the investment-grade line falls belongs with bond ratings; what belongs here is that a higher yield on a lower-graded issuer is the compensation for a greater chance of loss, priced by a market that has seen the same rating.

A company issues bonds, receives the money, pays interest on a schedule, and repays the face value at maturity. If it fails to do either, the bondholders become creditors in a restructuring or a liquidation, where what they recover depends on where their particular bonds rank and what assets exist.

A hypothetical example of the call asymmetry, using round figures rather than any current rate. Marcus buys $10,000 of a 20-year corporate bond at face value with a 6 percent coupon, so $600 a year. The bond is callable at face value after five years.

Case one: rates fall, and comparable new bonds are being issued at 4 percent. The company refinances and calls the bond in year five. Marcus receives his $10,000 back and can now buy a new bond only at 4 percent, so his income from that money drops from $600 to $400 a year, a reduction of $200 a year for the fifteen years he expected to keep receiving $600.

Case two: rates rise, and comparable new bonds are being issued at 8 percent. The company has no reason to call a bond costing it 6 percent, so Marcus keeps a below-market bond for the full twenty years, collecting $600 while new money earns $800.

The company chose in both cases, and both choices went its way. That is the whole content of call risk, and it is why a callable bond has to pay more than an otherwise identical bond that cannot be called.

A second hypothetical, on recovery. Suppose the company defaults and the eventual recovery is 40 cents on the dollar for senior unsecured bondholders and 15 cents for subordinated holders. On $10,000 of face value that is $4,000 against $1,500. Both holders lent to the same company, on the same day, and read the same financial statements. What differed was a ranking term in the documents.

Pros

• Higher yields than government bonds of the same maturity, and the difference is a visible, comparable price for the extra risk.
• Payments and the repayment date are contractual, so the outcome is knowable in advance if the company pays.
• A senior claim ahead of stockholders, so a corporate bondholder is being settled with while shareholders are waiting to see whether anything remains.
• A very wide range of issuers, maturities and credit qualities, so a position can be shaped precisely.
• Interest arrives as cash on a schedule without selling anything.

Cons

• The company can fail, and a bondholder's upside is capped no matter how well it does instead.
• Ranking among bondholders decides recovery, and a subordinated position can lose far more than a senior one in the same default.
• Callability lets the issuer take the good outcome and leave the bad one, which is why the extra yield on a callable bond is not free money.
• Interest is taxable federally and by the state, the least favorable of the three main bond categories.
• A downgrade reduces the price of a bond already held even if every payment is still being made.
• Individual issues can be hard to price and to sell, and the trading cost is built into the price rather than billed separately.