Bonds, Notes, and Debentures
Today we will review longer term fixed income securities.
There is some differentiation in the way that people define these assets. Many define a bond as a debt instrument that is secured against specific assets of the issuer. Bonds may also be seen as any debt exceeding 1 year in term to maturity.
No one way is the “right way”. But we will go with my terminology to stay consistent in my posts.
Bonds, Notes, and Debentures
I tend to aggregate bonds, notes, and debentures as just “bonds” for discussion purposes. That is because most of their characteristics are very similar. Plus, when you look at fixed income in the investment world, the short form for these three defaults to bonds. Where there are differences between the three, I shall definitely point them out.
Like short term money market instruments, all bonds are fixed-obligation debt securities.
Investors invest in the debt issue. In return, the issuer agrees to pay a certain amount of interest at pre-determined dates over the term of the debt. At maturity, the issuer agrees to repay the principal amount of the debt to the investors.
Bonds may be issued from many sources. Corporate, as well as issues from the various levels of government.
Term to Maturity
Unlike money market instruments, bonds are longer term obligations. I divide debt maturities into three time horizons:
Money market instruments are short term debt issues that mature in 1 year or less.
Notes are intermediate term debt issues with maturities between 1 and 10 years.
Bonds are long term debt issues with maturities greater than 10 years.
Not hard and fast rules on terms and maturities. But those terms are the most commonly used.
When I refer to short, intermediate, and long term debt issues, the characteristics of the bond change as it moves toward maturity. The name of the bond does not change from bond to note to money market. But, as we will see in our pricing discussion later, the major determinant of price volatility is the remaining term of the bond.
For example, General Motors issues a 30 year bond on January 1, 1991. It will mature and its face value repaid to investors on December 31, 2020. At issue, this would be considered a long term bond of 30 years. However, if it traded in the secondary markets and you purchased it on June 1, 2014, you would actually be acquiring a bond with intermediate term characteristics as the time to maturity was less than 10 years but more than 1. And if you sell the bond on June 1, 2020, it will be considered a short term debt security when pricing the bond, although not a money market instrument.
Types of Issues
Secured Bonds
Bonds that are backed by legal claims on specific assets of the issuer. That is, if the issuer defaults on the bond, investors have a claim against the specified collateral on the issue.
You may see secured bonds referred to as “senior” or “mortgage” bonds.
Senior bonds are often secured, but do not have to be. In the event of a default, a senior bond will have priority over other subordinate debt issues when the company pays out any money. A very useful feature should an issuer in financial distress have more debt outstanding than cash available. As a senior debt holder, you move to the front of the line for repayment. In essence, that is an investor’s security.
Mortgage bonds have mortgages secured (attached) to specific assets. Usually real estate or real property such as operating equipment. In the event of non-payment, these assets may be seized by the bond holders and sold to pay off the issue. Again, this provides security that the face value of the bond can be repaid.
A good example of secured debt is the mortgage on your house or the loan on your car. Until you have fully repaid the debt, the lender has a lien on the home or vehicle. Should you miss your payments, the lender may seize those specific assets detailed in the loan agreement.
The same holds true for secured bonds.
Unsecured Bonds
Also known as debentures, unsecured bonds are not backed by specific assets. Instead, the issue is supported only by the general promise from the issuer to pay interest and principal on the agreed dates.
Debt of this nature is part of the issuer’s general credit obligations. Should the issuer fail, debt holders would be one of many creditors fighting for a piece of the entity’s remaining assets.
Subordinated Bonds
Subordinated bonds, or junior debentures, only hold a claim on assets that is lower in position or seniority to other debt obligations.
Subordinated bonds may or may not be secured against specific assets. If they are secure, then there is already senior debt in place that takes precedence in the event of default.
A common example would be a second or third mortgage on a piece of real estate, such as your home.
If you hold the secondary claim and there is a default, you will wait in line until after the senior debt holders are repaid.
When investing in secured, subordinate bonds, be careful as to the assets you are linked with. An indenture will tell you the key details of a bond issue. The indenture is the legal contract between the issuer and the debt holder which specifies the issuer’s legal requirements.
If there is already enough senior debt to consume the asset’s entire value, then you really have no security at all. This needs to be factored into the pricing of the bond. With no practical security, the bond becomes riskier and investors require additional compensation for that increased risk.
The same logic applies to junior debentures. But here, there is no security. The debt holder is simply one of many creditors trying to get their money back if a default occurs. Standing in the back of the line waiting for more senior debt holders to be repaid is a risky proposition.
Unless the potential returns are high enough to justify the risk (in your eyes) or the issuer is one with an impeccable credit rating (e.g., US Government), I would suggest that you avoid debentures as a direct investment option.
Relevance for Investing
Ceteris paribus, it should be obvious that investors prefer secured bonds over unsecured and senior over junior issues.
Security
Whether you are investing in public debt issues or loaning money to your brother-in-law, always attempt to get as much security as possible in return. The more security you can get, the safer your investment.
That said, you need to also consider the liquidity and potential for decrease in market value of the collateral. If it is not liquid, or if the collateral can only be sold at distressed levels (a.k.a. fire sale prices), the security you possess might not cover all the debt owed.
For example, you are considering investing in a new debt issue by Sadco. They plan to expand operations in Dictatorland; a country with rumours the government may nationalize foreign company assets. This concerns you, so you only wish to invest in a secured bond issue. As the pledged assets are worth three times the bond value, you decide to invest.
Good strategy.
Unfortunately you did not read the indenture or prospectus and notice that the pledged assets were the company’s operating facilities in Dictatorland. In short order, the facilities are seized and Sadco files for bankruptcy. Good thing you had a secured bond. Now if only you can get the President-for-Life to agree to release the assets to you.
The same securitization issue applies to (say) operating equipment in a factory. New, the equipment may be worth $100 million and amply cover as security for a 20 year, $50 million bond offering. But, like your car, computer, motorboat, etc., over time general wear and tear erodes market value. If the issuing company experiences financial difficulty 10 years out, do you think the equipment will be worth its value brand new?
Any security or pledged assets attached to a debt offering should be worth more than the offering through its term to maturity. If not, is it really protection for your investment? Nope.
Just because a bond is “secured”, does not mean it practically is. Worth remembering.
Risk-Return Principle
If you cannot get proper security, then you need to receive a higher return for the additional risk you face on the debt.
This is a basic risk-return principle. The higher the risk, the greater the return required.
In this post, the greater return will likely come from higher interest payments or deeper discounts on pricing. You can see the level of security offered by a bond issuer plays an important role in the pricing and yield to maturity of any debt issue.
But more attractive returns may also involve sweeteners, such as equity conversion privileges or warrants. Anything that may make the offering more enticing to potential investors as compared to other issuers’ debt.
Before investing, ensure you know which of the above categories your investment resides within. Then compare that issue with other similar offerings to ensure that you receive the appropriate expected return for the assessed level of risk.
Debt with relatively less security will provide higher returns than debt with good security.
For most investors, it may not be prudent to directly invest in individual debentures or junior debt issues. However, you can use diversification techniques to reduce the portfolio risk and still enjoy the higher returns. This may mean investing in multiple offerings to spread out the investment risk. Or to invest in higher risk bonds through mutual or exchange traded funds, so as to spread the risk even more than you could do on your own with limited resources.
When we review portfolio construction we shall look at diversification tactics in some detail.
As for assessing the investment risk, we have reviewed some issuer specific, non-systematic risk factors here and here. We will also look at a few additional bond considerations shortly.
Next up though, a look at some common bond issues you will see in the marketplace.