Corporations that issue debt (bonds and notes) that are not backed by a specific asset are known as debentures. These bonds are backed by the full faith and credit of the company. Most of the bond issues are obligations.
Unsecured corporate bonds offer higher rates of return than covered bonds. When a bond is guaranteed, it is backed by a guarantee. That collateral could be “cash, securities, real estate, or equipment.”
Obligations are classified by their credit quality so that investors can make an informed decision. The lower the rating, the higher the return or rate of return. “Higher risk equals higher return.” That is true for all investments and it certainly includes investments in bonds. The top 2 rating companies are Standard and Poors (S&P) and Moodys. Based on their ratings, the bonds will be priced to sell at the minimum yield investors will need to buy them.
Its classification system breaks down as such:
S and P
Triple A: the highest rating an obligation can receive.
AA
TO
BBB
BBB and above is considered investment grade. Investment grade bonds are normally a good risk and default is remote. Investors looking to protect their capital with unsecured bonds should only invest in investment grade issues.
Speculative or “junk” bonds are rated lower starting at BB.
Bed and breakfast
B
CCC
and so …
Moodys has a similar rating system for bonds. They use some lowercase ratings to differentiate themselves from S&P.
Moodys
(Investment grade)
Triple A
AA
TO
Bleat
(Speculative)
Licensed in letters
B
That has
If a corporation does not make interest payments or does not return principal of the par value when the obligations are due, the company will be in default. If the company closes, it still owes the money to investors. Obligations are paid after other obligations and secured debt are paid. In the event of liquidation, they are paid ahead of shareholders, but not above other covered bondholders.
The bonds always have a higher rate than US Treasuries with the same maturity. US Treasuries are the safest bond issues, so for corporate issues to sell, they must offer an attractive spread over Treasuries.
The obligations are fully taxable. Any interest earned is subject to federal, state, and local taxes. Since they are fully taxable, their coupon rates are higher.
Subordinated debentures are the same as debentures in most ways. They are backed by the full faith and credit of the company. However, subordinated obligations pay a high rate, but have a lower priority if the company closes. Subordinated issues are the last bonds to pay. They are the last creditors, before the shareholders, who are paid. Not all companies offer subordinated obligations. The risk is obvious, but if the company does not liquidate, investors will benefit due to the higher rate of return. Their rating is normally lower compared to similar bond issues.
Corporate bonds may be enforceable by the issuer. Call dates can be placed on the bond and this allows the company to redeem the bonds early from the established dates and at established redemption prices. Typically this is not a good feature for investors, because an issue is typically called when interest rates are low, lower than your coupon rate. The main reason they are called debentures or bonds in general is because the issuer wants to roll over its debt at a lower rate. When this happens, the investor is faced with early repayment of his money (even), but the highest paying bond no longer exists. To make matters worse, interest rates are the lowest in the market, so finding a suitable replacement will be difficult, if not impossible. However, redeemable bonds pay a higher return, so for some the risk is worth it.
Corporate obligations have a place in all bond portfolios.
Know the yield to maturity of all bonds.
Good luck!
American Investment Training