The Debt Markets (part B)
by
Charles Lamson
The Corporate Bond Market
As the name implies, corporate bonds are issued by corporations. Investment bankers like Merrill Lynch, Salomon Smith Barney, and Bear Stearn design, market, and underwrite new corporate bond issues. The terms of the offering, along with other provisions, are spelled out in the bond indenture when the bonds are issued. The indenture is made out to a trustee representing the investors who buy the bonds. The trusty usually works for a bond or trust company and is an expert in interpreting the provisions of the offering for the investor. The trustee also sees that the issuer fulfills the terms and conditions of the indenture.
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Bonds may be backed by specific collateral such as real or personal property. The collateral can include plant, equipment, and financial assets that the issuing corporation owns. Debenture bonds are not backed by specific collateral, but in the event of a default, have a general claim on the otherwise unpledged assets of the issuer. Finally, subordinated debenture bonds are not backed by collateral and have a general claim after debenture bondholders have been paid. Thus, in the event of a default, owners of subordinated debenture bonds are the last bondholders in line to receive any funds. As we would expect, other factors being equal, subordinated debenture bonds pay the highest return, followed by debenture bonds, followed by bonds backed by collateral.
Some bonds also come with financial guarantees issued by insurance companies. The bond issuer pays a premium that guarantees the payment of interest and principal by the insurance company in the event the issuer defaults. In reality, the credit of the guarantor is substituted for the guarantee of the issuer. The bonds are issued at a lower interest rate than otherwise because of the guarantee. It is beneficial to the bond issuer to pay for the financial guarantee if the present value of the interest savings over the life of the bond is greater than the insurance premium.
Some firms also issue zero-coupon bonds, which as their name implies, do not have coupons and do not make coupon payments. Instead, the bonds are sold at a discount with the difference between the amount paid for the bond and the amount received at maturity being equal to the interest. The advantage to the investor is that there is no risk that the internet over the life of the loan and taxes are paid on the amount of the interest earned each year, even though the interest is not paid until the bond matures. An advantage for the corporation is that interest payments are written off on an annual basis, even though they are not paid until the bond matures.
The secondary market in corporate bonds is a loosely connected array of brokers and dealers who buy, sell, and take positions in bonds in an over the counter market. In an over-the-counter market, brokers and dealers buy and sell bonds over computer links and telephone lines. Although the bulk of bond trading takes place over the counter, some bonds are also bought and sold on organized exchanges such as the New York Stock Exchange.
Specific bonds trade with varying degrees of liquidity in the secondary market. Other factors being equal, the greater the expected liquidity, the lower the yield.
Recap
Bonds are debt instruments that may be issued by domestic or foreign governments and corporations. The terms of a corporate bond issue are spelled out by the bond indenture and interpreted by the trustee. Some bonds are backed by real or financial assets that the corporation owns. Debenture bondholders are entitled to be paid before subordinated debenture bondholders but after bondholders with bonds that are backed by specific collateral. Zero-coupon bonds are sold at a discount. Secondary markets for bonds are primarily over-the-counter markets.
*THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 408-410*
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