Governments and corporations may issue plain vanilla debt. At, or near, par with fixed, periodic interest payments.
Or they may add chocolate sauce or sprinkles. Like Baskins-Robbins, there are a multitude of options for the more adventurous debt issuers and investors.
Here are a few common bond variations you may see issued, mainly by corporations due to their nature. All of these potential features are utilized to attract investors. Thereby reducing the interest rates they would otherwise have to pay.
Note that the following are secured bonds, which we previously discussed.
Mortgage Bonds
Bonds that are backed by a pledge of real property, such as buildings or land, as collateral for the debt issue. Exactly like the mortgage on your home.
If the company defaults, bond holders have a claim to the pledged assets. Like your bank with your mortgage.
As I mentioned previously, you need to consider the liquidity and the market value of the collateral. Just because the pledged asset has a book value in excess of the bond issue does not mean that you will get that amount should you have to sell the asset to pay off the bond holders.
This same point applies to all the items below as well.
Note that mortgage bonds are not the same as “mortgage backed securities” (MBS). An MBS is a pool of mortgages that are bundled together. Units are then issued to investors who receive a flow through of interest and principal from the pooled mortgages.
Collateral Trust Bonds
Bonds where the corporation pledges financial securities (stocks and bonds) that it owns as collateral.
This is useful for companies that lack equipment, real estate, receivables, or operating facilities to use as collateral.
The riskiness of this is based on the liquidity and volatility of the pledged assets.
If the pledged securities are US government Treasury bills, then the risk is minimal. If the collateral is shares of small, private companies, then liquidity may be poor and the volatility very high. When the shares are doing well, there may be ample coverage for the debt issue. But if the shares enter a bear market (downward cycle), you may quickly find that there is not enough collateral to cover the debt issue.
Equipment Trust Certificates
Bonds issued by transportation companies where “rolling stock” is pledged as collateral.
“Rolling stock” is anything with wheels (automobiles, trains, airplanes, etc.).
In addition to liquidity issues, you need to consider market value versus book value.
Book value is the asset’s value on a company’s balance sheet. It will take purchase price and reduce the value each year for calculated depreciation.
Assume that a freight train will last 20 years, costs $10 million to buy, and will be depreciated by the same amount each year over its expected life. In this example, depreciation would be $500,000 each year. After the first year the book value would be $9.5 million. After year 10, $5 million. And after year 20, there is zero book value.
Market value though, is what the asset is actually worth on the open market.
After year 1, the book value is $9.5 million. However, if you want to sell the train and have time to wait for a proper buyer, you may only get $7 million for it. Or, if you need to immediately sell the asset tomorrow, you might only get $4 million under fire sale conditions.
Conversely, at the end of year 20 the book value is zero. But perhaps there is still some life in the asset and you are able to sell it for $1 million.
Book value is simply a calculation. It is the actual market value that is important when you need to buy or sell an asset.
Certificates for Automobile Receivables
Debt that is secured by loans on auto purchases.
Maybe you decide to purchase a new vehicle and finance the car through the auto company over 5 years. Other buyers around the world do exactly the same thing. The car maker then bundles all the loans together and pledges them against the debt issue.
The interest and principal that is paid to the car maker by the individuals should cover the interest and principal paid by the car maker to the debt holders.
By bundling a wide variety of individual loans together, the risk of default decreases and each separate loan has minimal impact on the overall loan portfolio. However, if there is a widespread economic catastrophe (e.g. a depression occurring) and many of the individual loans default, this will make payments by the car maker difficult.
Those are some common examples of debt issues along with a few things to think about. Key is the risk-return relationship. Any bond feature that reduces riskiness of investors receiving their interest and original principal, allows the issuer to pay less interest.
