Corporate Bonds and the Language of Debt

A corporate bond is a loan you make to a company. The company promises to pay interest, then return your money on a set date. Every debt product on the exam uses the vocabulary below, so learn it once here.

Par, coupon, and maturity

Three numbers describe any bond.

• Par value is the amount the issuer repays at the end. Corporate bonds almost always carry a par value of $1,000. Par is also called face value or principal.
• The coupon is the annual interest rate the issuer promises, stated as a percentage of par. A 6% coupon on a $1,000 bond pays $60 a year, usually in two $30 payments six months apart.
• Maturity is the date the issuer repays par. Short-term means under three years, medium-term means four to ten, and long-term means more than ten.

Par never changes. The price does. Bond prices are quoted as a percentage of par, so a quote of 98 means $980 and a quote of 104 means $1,040. A price below par is a discount, and a price above par is a premium. A new issue usually comes to market at par.

Prices fall when rates rise

Bond prices and interest rates move in opposite directions.

You own a bond paying $60 a year. New bonds of the same quality now pay $80. Nobody pays $1,000 for a $60 stream when $80 is available, so your bond's price drops until its return matches the market. If new bonds paid $40, buyers would bid your bond above par.

Rates up, prices down. Longer maturities move the most, because the outdated coupon is locked in for more years.

The four yields

Yield measures your return against what you paid.

• Nominal yield is the coupon rate. It never changes: $60 on a $1,000 par bond is 6% for the bond's whole life.
• Current yield is the annual coupon divided by the current market price. Buy that 6% bond at $800 and the current yield is $60 / $800, or 7.5%.
• Yield to maturity (YTM) is the total return if you hold the bond to maturity. It counts the coupons plus the gain or loss between your price and par.
• Yield to call (YTC) runs the same calculation to the call date and the call price instead.

Buy at a discount and every yield sits above the coupon rate, because you also collect the climb back to par. Buy at a premium and every yield sits below it, because the premium disappears by maturity.

For a discount bond callable at par, the exam ranks the yields from highest to lowest:

• Yield to call
• Yield to maturity
• Current yield
• Nominal yield

A premium bond reverses that order.

Ratings and the investment grade line

A credit rating is an agency's opinion of the risk that the issuer fails to pay. Three agencies rate most corporate debt: Moody's, Standard & Poor's, and Fitch.

The dividing line matters more than the letters. Investment grade runs from the top rating down to BBB- (Baa3 at Moody's). Anything below that line is non-investment grade, also called high yield, speculative, or junk. A weaker issuer must pay a higher interest rate to find buyers.

A rating covers default risk and nothing else. A top-rated bond still loses market value when rates rise. Agencies change their ratings, and a downgrade drops the bond's price even while the issuer keeps paying on time.

Callable and convertible: whose choice is it?

A call feature lets the issuer redeem the bond early, at a stated call price, after a stated date. Issuers call when rates fall, the same way a homeowner refinances a mortgage. That hurts you twice: you lose the high coupon and you reinvest at today's lower rate. Callable bonds pay a higher coupon to compensate you for that risk.

A conversion feature lets you exchange the bond for a fixed number of the issuer's common shares. The conversion ratio is par divided by the conversion price. A $1,000 bond with a $40 conversion price converts into 25 shares. If the stock climbs to $50, those 25 shares are worth $1,250, and the bond's price follows the stock. You pay for that upside with a lower coupon than a comparable non-convertible bond.

The call belongs to the issuer. The conversion belongs to you. The exam tests exactly that split.

Secured, unsecured, and who gets paid first

A secured bond pledges specific collateral, such as property or equipment. If the company defaults, the holders can foreclose on that collateral.

An unsecured bond rests on the general credit of the issuer and pledges no collateral. Its name is a debenture. A subordinated debenture, also called a junior debenture, ranks behind the senior debentures.

In bankruptcy the order runs: secured bondholders, then senior debenture holders, then subordinated debenture holders. All of them come before preferred and common stockholders. Bondholders are lenders and stockholders are owners, and owners get paid last.

Negotiated and competitive offerings

An issuer brings new bonds to market one of two ways.

• In a negotiated offering, the issuer picks its underwriter first, then settles the price, the coupon, and the underwriter's fee by discussion.
• In a competitive offering, the issuer publishes the terms and takes sealed bids from underwriting syndicates. A syndicate is a group of broker-dealers formed to buy a deal and resell it. The syndicate offering the issuer the lowest borrowing cost wins.

Nearly every corporate bond deal is negotiated. Competitive bidding is common on general obligation municipal bonds.

How this gets tested

Most questions here take one step. Work out which of these four it is asking:

• Rates moved, so which way did the price go.
• The bond trades at a discount, so which yield is highest.
• The bond was called or converted, so who made that choice.
• The company defaulted, so who gets paid before whom.