To understand corporate bonds, you must first understand key concepts about how the corporate debt relates to the issuer’s business capital structure and how the debt, itself, is constructed. These points are crucial for the investor to understand before investing in any corporate debt products.
Corporate bonds are fungible–have the ability to be invested into by investors–debt products. These bonds are available in a variety of risk-reward levels depending on the underlying company’s creditworthiness. Corporations will float bonds to finance expenditures and to fund day to day operations. Bonds are often more assessable to businesses than bank loans and often speed up the time-lag in receiving the needed funds.
There are separate classifications of bonds that dictate specifically how the bond relates to the capital structure of the issuing corporation. This is significant because the bond classification actually dictates the payout order in the event the issuer cannot meet its financial obligations–known as default.
When comparing debt to equity, debt always has seniority in the payout order. When comparing unsecured debt to secured debt, secured debt has seniority. For example, preferred stock-holders receive payout before common-stock shareholders do.
This is a ranking structure that is used by issuers to prioritize debt payout. At the top in this structure would be the senior “secured” debt for which the structure is named. This is in contrast to structures where the age of the debt places determines which has seniority. If a bond is classified as a secured bond, the issuer is backing it with collateral. This makes it more secure (usually having a significantly higher recovery rate) in the event the company defaults. Examples of this are companies that issue a secured corporate bond by backing it with assets like industrial equipment, a warehouse or a factory.
Any security labeled “senior” in such a structure is one that takes primacy over any other company’s sources of capital. The most-senior securities holders will always be first to receive a payout from a company’s holdings in the event of default. Then would come those security-holders whose securities are deemed second-highest in seniority, and so forth until the assets used to pay off such debts run out.
Senior unsecured corporate bonds are in most respects just like senior secured bonds with one significant difference: There is no specific collateral guaranteeing them. Other than that, such senior bondholders enjoy a privileged position in the event of default with respect to the payout order.
After the senior securities are paid out, the junior, unsecured debt will next be paid out from what assets remain. This is unsecured debt, meaning no collateral exists to guarantee at least a portion. Bonds in this category are often referred to as debentures.
Such unsecured bonds only have the issuer’s good name and credit rating as security. Junior or subordinated bonds are named specifically for their position in the payout order: Their junior, or subordinate, status means they only are paid out after senior bonds, in the event of a default.
These bonds are guaranteed in the event of default not by collateral, but by a third party. This means that in the event the issuer cannot continue to make payouts, a third party will take over and continue to make good on the original terms of the bond. Common examples of this category of the bond are municipal bonds backed by a government entity or corporate bonds backed by a group entity.
Such insured bonds possess the second level of security in that you have the credit rating of two separate entities instead of just one to rely upon to secure the bond. However, this second entity can only provide as much security as its own credit rating allows, so it’s not 100% insured. Still, guaranteed or insured bonds are much less risky than non-insured bonds, and thus typically carry with them a lower interest rate. Insured bonds will always have a higher credit rating because there are two companies guaranteeing the bond. However, this security premium comes at the cost of a reduced final yield on the bond.
Some corporate bond issuers hope to attract investors by offering convertible bonds. These are simply bonds that the bondholder may choose to convert into common stock shares. These shares are typically from the same issuer and issued at a preset price even if the stock’s market price has grown since the bond was first issued.
The price of convertible bonds is a bit more fluid as they are rated upon the company’s stock price and prospects at the time they are issued. Additionally, because these convertible bonds give investors expanded options, they typically have a lower yield than standard bonds of the same size.
The recovery rate for a corporate bond or any similar type of security refers to the amount of the bond’s total value. This includes both interest payments and the principal that are likely to be recovered in the event the issuer defaults. This recovery rate is typically expressed as a percentage that compares its value during a default to that of the par value of the bond. Or, to put it more simply: The recovery rate is the corporate bond’s payout value in the event of a default.
Recovery rates are widely popular as a way to help investors estimate the potential for the risk of a loss the corporate bond presents, which is typically expressed as a loss given default (LGD). So, for example, if an investor was considering a $100,000 bond investment (principal) with a recovery rate of 30%, the LGD would be 70%. This means that in the event of default, it is estimated the payout would be 30% of the principal, or $30,000. So the LGD in this example is $70,000.
Recovery rates may vary significantly from bond-to-bond and issuer-to-issuer. Relevant factors include:
The security type of a corporate bond: Higher seniority bonds and securities enjoy a higher recovery rate than subordinate instruments. In fact, a bond’s recovery rate is directly proportional to its payout seniority in the event the issuer defaults (though factors such as industry and collateral are important as well). Nada Mora, an economist for the Federal Reserve Bank of Kansas City, conducted a sample study and comparison of recovery rates on different debt instruments and found the following results. When comparing senior secured bonds to senior unsecured bonds the secured debt recovery rate was 56% and the unsecured debt recovery rate was 37%. In general, investors can expect senior secured debts to enjoy the highest recovery rates. Subordinated debt recovery rates were 31% and the junior subordinated debt recovery rate was lowest at 27%.
Macroeconomic conditions: There are several macroeconomic conditions that can directly affect the recovery rate of any security or corporate bond. These include the overall default rate, the current stage of the larger economic cycle, and general liquidity conditions. For example, a recession in which many companies are defaulting may negatively impact a security’s recovery rate (this has been clearly observed in the financial crisis of 2008).
Individual factors concerning the issuer: There are factors within the company itself that could affect the recovery rate of the bonds and security instruments it issues. These include its overall level of debt, equity level, and capital structure, to name a few significant ones. In general, what it boils down to is this: The lower a company’s debt-to-asset ratio is, the higher the recovery rate investors can expect.
Any investor in corporate bonds or any other debt instrument should pay significant attention to the security classification of the debt. The different security types are directly linked to the potential recovery rates in the event of a corporation’s default. Moreover, other factors affect the recovery rate, which at any stage should also be taken also into account.