Bond Basics: Different Types Of Bonds

Debenture bonds
Most corporate bonds are debentures – that is, unsecured debt obligations backed only by the issuer’s general credit and the capacity of its earnings to repay interest and principal. However, even unsecured bonds usually have the protection of what is known as a negative pledge provision. This requires the issuer to provide security for the unsecured bonds in the event that it subsequently pledges its assets to secure other debt obligations.

Credit ratings are a key tool for the average investor who wants to know how strong a company’s unsecured bonds are.

Mortgage Bonds
These are bonds for which real estate or other physical property worth more than the bonds has been pledged as collateral. They are mostly issued by public utilities.

There are various kinds of mortgage bonds, including the following: first, prior, overlying, junior, second, third and so on. The designation reflects the priority of the lien, or legal claim, you have against the specified property.

Any time you invest in mortgage bonds, you should find out how much other debt of the issuer is secured by the same collateral and whether the lien supporting that other debt is equal or prior to your bond’s lien.

Collateral Trust Bonds
A corporation may deposit stocks, bonds and other securities with a trustee to back its bonds. The collateral must have a market value at least equal to the value of the bonds.

Equipment Trust Certificates
Railroads and airlines have issued this type of bond as a way to pay for new equipment at relatively low interest rates. The title to the equipment is held by a trustee until the loan is paid off, and the investors who buy the certificates usually have a first claim on the equipment.

Subordinated Debentures
Debt that is subordinated, or junior, has a priority lower than that of other debt in terms of payment (but like all bonds, it ranks ahead of stock). Only after secured bonds and debentures are paid off can holders of subordinated debentures be paid. In exchange for this lower status in the event of bankruptcy, investors in subordinated securities earn a higher rate of interest than is paid on senior securities.

Guaranteed Bonds
Another form of security is a guarantee of one corporation’s bonds by another corporation. For example, bonds issued by a subsidiary may be guaranteed by the parent corporation. Or bonds issued by a joint venture between two companies may be guaranteed by both parent corporations. Guaranteed bonds become, in effect, debentures of the guaranteeing corporation and benefit from its presumably better credit.

High-Yield Bonds
Bonds with a rating of BB (Standard & Poor’s, Fitch and Duff & Phelps) or Ba (Moody’s) or below are speculative investments. They are called high-yield, or junk, bonds.

Such bonds are issued by newer or start-up companies, companies that have had financial problems, companies in a particularly competitive or volatile market and those featuring aggressive financial and business policies.

They pay higher interest rates than investment-grade bonds to compensate for the extra-risk. (However, if they were issued before the company’s financial difficulties, the risk may not be offset by a higher yield.) For those who do not mind taking substantial risk, such securities can provide exceptional returns. For the less adventurous who still want to participate in this market, high-yield bond mutual funds are a way to spread the risk over many issues.

Event Risk
In recent years, the management of many corporations have tried to boost shareholder value by undertaking leveraged buyouts, restructurings, mergers and recapitalizations. Such events can push bond values down, sometimes very suddenly, because they may greatly increase a company’s debt load. Although some corporations have now established bondholder protections, these are neither widespread nor foolproof. An individual investor should see if the rating agencies have written commentaries on a company’s vulnerability to event risk before buying its bonds.


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