Investing 101

Just like ice cream, bonds come in flavors

Senior Debt typically is the safest and most secure type of bonds in a corporate balance sheet. If the company ever ran into bankruptcy problems, the first type of bond to be paid would be the senior obligation bonds. Just below that would be junior obligation bonds. There are other bonds that are backed only by specific assets of a company. For example, airlines typically have separate bonds secured only by the airlines they lease themselves. If you had a chain of chocolate pretzel stands with a unique formula for chocolate that you knew See’s would pay you $1M to have, you could likely borrow half that or so in the form of a bond backed only by your grandma’s secret formula. This type of bond is called an asset backed bond.

Another common form is a debenture. Debentures are the lowest on the priority stack of bonds should something go wrong. Debentures are backed only by the full faith and credit of the company, meaning the company promises to pay back the bond (unless it can’t). Why would a person ever loan money only based on the company’s promise and nothing tangible? If a company ever refused or couldn’t pay any form of bond, it usually spells the end of the company’s credit or trust from all of the company’s vendors, shareholders and board. A debenture not paying is more or less as cataclysmic to a company’s financial health as any other form of bond.

Because debentures are low on the risk stack, they typically come with one other feature: convertibility. That is, $1000 of United bonds might be convertible into 50 shares of United Airlines Series A common stock. Doing fancy math, that means that if the share price ever went meaningfully above $20, it would make sense for the bond holders to convert their bonds into equities and make a nice profit.

A Zero Coupon bond is a type of bond which pays no cash interest along the way (hence the zero coupon or zero payment). At the end of the bond’s obligation period, both the principle and all of the accrued interest come due. For example, if you borrowed $1000 for 7 years, at 12% rate of interest, you would get nothing along the way and roughly $2000 (more with compounding) at the end in one lump sum payments. Zero coupon bonds are perceived as being more risky because coming up with that final lump sump payment at the end is sometimes difficult for corporations. To stem some fears, most corporations create what is called a sinking fund which is an amount of money, they “sink” into a piggy bank for the day that money comes due. In the case of a seven year zero, the company might put 1/7 of that money into its own bond which matures when the rest of the bond matures so paying off the accrued interest and principle is less painful.

Next Page: How the Government Participates
Previous Page: Why You Should Care About Bonds