Corporate Bonds

Companies put cash in their bank accounts in a few basic ways. 1) They sell equity or ownership or shares of themselves like in an IPO. 2) They can make money from selling their product; that is, a single shingle sells for $19.95 and they keep $4.82 in profits from it. Times ten million...is a lot of cash. And 3) they sell bonds. Or rather, debt. That is, they pay rent for borrowing money just as governments do.

What do Microsoft, Coke, and your deadbeat uncle all have in common? They all have debt outstanding.

Most companies (like...well over 99% of them) boringly pay off their interest…and when the bonds come due however many years or decades later, they pay the principal and they’re done.They’ve presumably used the money wisely. But the more interesting bond stories revolve around the times when companies' best-laid plans go awry, and they snuggle up real close next to bankruptcy.

Example time.

If our roofing company, We've Got Shingles, has 90 million bucks in pre-tax profits, they might have 1.6 billion dollars of bonds with an interest rate of 5%. The interest costs are 80 million a year, so the company is only making 10 million dollars...juuuust enough to cover the interest.

Should profits fall, the company would go into default, miss an interest payment...and then, in theory, the bondholders could repossess the company. The bondholders could take control of it, sell off assets to pay themselves back and, well…the company usually then dies. So...that’s not good.

And that’s why the bonds are called junk. Or, in more proper parlance, “high yield.”

They live waaaaay to the right on the risk spectrum, because that whole snuggling up right next to bankruptcy is not something Wall Street people like doing. Childhood intimacy issues, probably.

So, while a very safe U.S. Government 10-year bond might pay 3%, a similar but very junky corporate bond might pay 12% or more to adjust for the vastly higher degree of risk.