The corporations of America raise funds for operational purposes by selling assets, by retaining internally generated funds (profits), by issuing stock and by issuing bonds.
Bonds mean indebtedness; the bondholder is a creditor. The buyer lends the corporation money for a certain period of time (the maturity) at a fixed rate of interest (the coupon).
The corporation agrees to pay the purchaser the amount of money (principal) that was loaned plus a rate of interest on that money so long as the loan, or bond, is outstanding. All the terms are stated in the bond's indenture, which is the place to look if there are ever any questions concerning the claims the buyer might have against the issuer.
Bonds may be backed or secured by rolling stock (railroads), natural resources (mining companies), securities (collateral trust notes), mortgages (mortgage-backed securities) or, in the case of most public utilities, by a lien on specific property (a mortgage). However, bonds may be issued without any backing (unsecured) except for the good name or the credit of the corporation. This type of debt is called a debenture.
All of the pertinent information about a new issue is available either in a "red herring" (preliminary official statement) prior to an offering or in the prospectus (final official statement issued after an issue has been priced).
Corporate bonds are sold to the public in one of two basic ways. They either are negotiated by a single syndicate or bid for competitively by several syndicates. In either case, a syndicate made up of various brokerage houses and headed by a lead underwriter markets the issue. Only the proceeds from the initial offering go to the corporate borrower. Many brokerage houses maintain a secondary trading market after issues are marketed. Maturities
Until the early 1970s, most corporate bonds were issued with a long life, or maturity (20 to 30 years). However, with the excessively high interest rates in '72-'74, and '79-'85, issuers began selling intermediate bonds with maturities of 3, 5, 7 and 10 years. In 1979, some 26 percent of all outstanding corporate bonds had maturities of 10 years or less. By the end of 1984, that figure had jumped to 42 percent.
These shorter bonds became especially appealing to individuals and trust departments. Short investments could be tailored to fit specific needs but, more importantly, funds committed to short maturities during periods of high inflation could be reinvested at frequent intervals at higher interest rates without the principal being eroded too much by inflation. Credit Risks
Of prime importance in purchasing a bond is the ability of the issuer to pay the semiannual interest and to repay the principal at maturity. This ability can be equated with risk which, in turn, manifests itself in the rate of return, or interest paid, or yield, on a particular bond. The poorer the credit rating of a company, the greater the risk and, consequently, the greater the yield, or return, on the bond. Conversely, the better the ability to pay the interest and principal, the less risk, and the less return, or interest.
Two major credit rating companies, Moody's and Standard & Poor's, examine the credit conditions of corporations and then rate them according to their financial soundness and ability to service their debt.
The ratings an individual should be concerned with are the top four (AAA, AA, A and BAA). Once you move below a BAA rating, the credit risks far outweigh the advantages for a prudent investor. Also, there are times when companies may be downgraded by the rating agencies. This will hurt the marketability and price of a particular issue. Call Protection
Call protection is an important consideration, especially when a bond is purchased during periods of high interest rates.
Call protection usually refers to the length of time before the issuing company legally may "call in," or pay off, an outstanding issue. For example, if you buy a new issue with a 12 coupon, you would like to keep that 12 percent return as long as possible. If, in a few years, interest rates decline to 7 percent, it would be to the advantage of the issuing corporation to pay off the 12 percent issue and replace it with a 7 percent issue (if legally possible).
Its ability to call in the 12 percent bonds would be stymied if the bonds are noncallable for 10 years. A good guide for the investor is that, the higher the interest rate, the more call protection should be sought. Additional protection may be obtained by buying a high-coupon bond at a discount from par ($1,000), if possible. For example, buying an 11 1/2 percent at 95 ($950) would increase the price appreciation if the bond is called at a price higher than par. Sinking Funds
Sinking funds provide a method of retiring a substantial portion of an issue prior to maturity to reduce interest costs to the issuer and to accumulate funds for debt retirement on a schedule. The issuer provides funds periodically for the trustee of the issue, who then retires the debt over a fixed period -- say in the last 20 years in the life of a 30-year bond.
Outstanding bonds are usually called by lottery. However, in many instances, when the bonds are selling at a discount from par ($1,000), the trustee simply will go into the open markets and make his required purchases.
Two benefits from a sinking fund issue are, first, when an issue is selling at a discount, the routine purchase by the trustee gives an added value to the issue because it supports the market for the issue and, second, as the debt is retired systematically, the security, or debt service, of the issue is enhanced because of the reduction of principal and interest. On the other hand, if a sinking fund begins to retire the bonds, the investor has earned interest on fewer bonds for a shorter amount of time. And, if the bonds are retired at par when they are selling above par, the investor also will lose that capital gain.
Sinking funds are found on most industrial bonds plus debt issued by extractive industries, i.e., gas and mineral companies. Some utilities bonds are issued with a sinking fund during periods of high interest rates. Ford Motor Credit Co. has utilized sinking funds on a couple of its issues. Types of Corporate Bonds
The major types of corporate bonds are public utility, industrial, finance and transportation bonds, which collectively had approximately $384 billion in straight debt outstanding at the end of last year.
Of these, public utililty issues outpace the others with about $163 billion outstanding. Telephone, electric and other energy companies make up the utility spectrum. Telephone bonds (formerly the AT&T system) are noncallable for five years. Most utilities are nonrefundable for five years. These two types of issues may be sold with intermediate and long-term maturities. Rating-wise, the individual investor should stick to the top four categories (AAA, AA, A and BAA).
* Industrial bonds. These do not come to the marketplace frequently, but when they do, they come in size, anywhere from $100 million to $500 million per issue.
At the end of 1984, there was $128 billion in industrial bonds outstanding. The main features of the longer issues are 10-year call protection and sinking funds. Most industrials are in the AA and A class, although from 1979 to the present, lower BB- and B-rated issues have been gaining a larger part of the new-issue market. All industrials are negotiated issues.
* Transportation bonds. The great majority of transportation bonds are railroad equipment trust certificates that are issued by the roads and collateralized by the equipment itself.
These are sold in serial form, that is, an issue will have maturities annually from one to 15 years. They are noncallable, and the longer maturities are in great demand, especially during periods of high interest rates. Depending on the particular issue, equips may come in registered or coupon form and in denominations as small as $1,000. These securities are mostly AA- and A-rated.
* Bank and finance companies. Finance companies occasionally sell long bonds, but more recently have used intermediate securities. The longer issues generally have 10-year call protection. One such company, Ford Motor Credit Corp., has several longer issues outstanding with sinking funds. The intermediates fall somewhere between three and 10 years with various call protection. Finance issues are available in $1,000 pieces in registered form only.
Bank financing has accounted for a large share of the market in recent years as the banks strive to increase their capital ratios. Many of the larger bank holding companies have used "floaters," bonds whose interest rates are tied to various indicies that change weekly, quarterly or semiannually. Most of the floaters are available in $1,000 denominations.
* Mortgage-Backed Securities. Mortgage backed securities made their debut in 1970. In the last three years, there has been an explosion in the use of this type of security.
Actually, it has become a bridge between U.S. Treasury and corporate issues. The mortgages generally have been government-backed, and the main issuers have been agencies or former agencies such as the Federal National Mortgage Association. Buyers should be aware that, because principal and interest is paid out to the investor, mortgage-backed securities are a self-liquidating investment. The final payment will be only a fraction of the original par, or face, value purchased.
The underlying basis for almost all mortgage-backed securities is the single-family home mortgage. Pools of these mortgages are created, and a security evidencing ownership in these pools is sold to investors. As the mortgages are paid down monthly, their principal and interest is "passed through" to investors according to their percentage of ownership in the mortgage pools. This payout may be monthly, as are Government National Mortgage Association and FNMA pass-throughs, or it may be semiannually, as in the case of Federal Home Loan Mortgage Corp. securities.
The stated maturities generally are 30 years or 15 years, but because of the self-amortization and prepayments of the mortgages, the actual life of these securities may be much shorter. The yield on mortgage-backed securities is usually figured or given on the average life of the mortgage pool. The average life of a pass-through security is the average number of years that each principal dollar will be outstanding.
Mortgage-backed securities offer investor quality (all rated AAA), a good cash flow, liquidity and higher yields than Treasuries. They all come in minimums of $25,000 and have no special tax treatment. Government bonds dealers make markets in most of these securities. The timing of their paydown may be unpredictable, and they should be completely understood by the investor and the person selling to the investor.
The main types of mortgage-backed securities are as follows:
* Government National Mortgage Association Pass-Through. The GNMA pass-through represents an interest in FHA-insured or VA-guaranteed mortgage loans and is backed further by the U.S. government as to the timely payment of principal and interest. No other mortgage-backed security has this government-backed guarantee. GNMA has several different programs, and uses 30-year and 15-year mortgages. They are issued in registered form, in minimums of $25,000, with the principal and interest being paid monthly in most programs. The income is subject to state and local taxes (unless specifically exempted by local governments) and federal income taxes.
* Federal Home Loan Mortgage Corp. Participation Certificate. This certificate represents an interest in a pool of conventional mortgages, and the FHLMC, as a government-affiliated agency, guarantees the timely payment of interest at the certificate rate and the ultimate collection of principal regardless of the status of the underlying mortgages. The payout on these securities is monthly, and they come in minimum denominations of $25,000. They are subject to federal, state and local taxes.
* FHLMC Collateralized Mortgage Obligation. A CMO is an issue of bonds collateralized by a large grouping of mortgages. The bonds are divided into four different tranches, or maturities, or classes. All principal payments from the underlying mortgage collateral are used to pay down the first class of bonds until they are repaid completely. Then all the remaining principal is used to repay the second class or maturity, and so on, until the entire issue is paid off. The CMOs are issued in minimums of $25,000, and they pay principal and interest semiannually. They are subject to federal, state and local taxes.
* FNMA Guaranteed Mortgage Pass-Through Certificate. This represents an interest in a pool of mortgages comprised of conventional or FHA/VA single-family mortgages. FNMA guarantees the payment of principal and interest, which is paid monthly. The FNMA PCs are issued in minimums of $25,000, and the interest is subject to federal, state and local taxes. Miscellaneous. Many corporate bonds are listed on the New York Stock Exchange, and active markets are maintained in the over-the-counter market by the large bond traders on the Street.
Unless you own an obscure or very old issue, it should be easy to follow the price level of the issue. New issues may be purchased from brokers listed in the "tombstone" ads that announce the sale of a particular issue. Many papers publish corporate bond calendars for that coming week. Your broker should be able to give you the particulars on any new issues.