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Trading and Capital-Markets Activities Manual

Instrument Profiles: Corporate Notes and Bonds
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

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 semi-annually 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 bondholder 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 bondholders 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 working capital, and limits on the payment of cash dividends by the issuer. If an 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 maEagle Tradersg within one year are usually viewed as the equivalent of cash items. Debt maEagle Tradersg 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 longterm debt matures in more than 12 years. 

Interest-Payment Characteristics 

Fixed-Rate Bonds 

Most fixed-rate corporate bonds pay interest semi-annually 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 nonconvertible 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. Non-financial 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 outstanding 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 service 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 provisions 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 corporate 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. (These factors and their effect on pricing are discussed in the ''Characteristics and Features'' subsection above.) 

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 behind 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 restrucEagle Tradersgs, 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. 

ACCOUNTING TREATMENT 

The Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,'' determines the accounting treatment for investments in corporate notes and bonds. SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 

RISK-BASED CAPITAL WEIGHTING 

Corporate notes and bonds should be weighted at 100 percent. For specific risk weights for qualified trading accounts, see section 2110.1, ''Capital Adequacy.'' 

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 Handbook 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. 4045.1 Corporate Notes and Bonds

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