A corporate bond can be secured or unsecured. We describe each type next.

Secured Debt

By secured debt it is meant that some form of collateral is pledged to ensure repayment of the debt.

Utility Mortgage Bonds Debt secured by real property such as plant and equipment is called mortgage debt. The largest issuers of mortgage debt are electric utility companies. Most electric utility bond indentures do not limit the total amount of bonds that may be issued. This is called an open-ended mortgage. The mortgage generally is a first lien on the company's real estate, fixed property, and franchises, subject to certain exceptions or permitted encumbrances owned at the time of the execution of the indenture or its supplement. The after-acquired property clause also subjects to the mortgage property acquired by the company after the filing of the original or supplemental indenture.

To provide for proper maintenance of the property and replacement of worn-out plant, maintenance fund, maintenance and replacement fund, or renewal and replacement fund provisions are placed in indentures. These clauses stipulate that the issuer spend a certain amount of money for these purposes. Depending on the company, the required sums may be around 15% of operating revenues. As defined in other cases, the figure is based on a percentage of the depreciable property or amount of bonds outstanding. These requirements usually can be satisfied by certifying that the specified amount of expenditures has been made for maintenance and repairs to the property or by gross property additions. They can also be satisfied by depositing cash or outstanding mortgage bonds with the trustee; the deposited cash can be used for property additions, repairs, and maintenance or in some cases the redemption of bonds.

Another provision for bondholder security is the release and substitution of property clause. If the company releases property from the mortgage lien (such as through a sale of a plant or other property that may have become obsolete or no longer necessary for use in the business), it must substitute other property or cash and securities to be held by the trustee, usually in an amount equal to the released property's fair value. It may use the proceeds or cash held by the trustee to retire outstanding bonded debt. Certainly, a bondholder would not let go of the mortgaged property without substitution of satisfactory new collateral or adjustment in the amount of the debt because the bondholder should want to maintain the value of the security behind the bond. In some cases the company may waive the right to issue additional bonds.

Although the typical electric utility mortgage does not limit the total amount of bonds that may be issued, certain issuance tests or bases usually have to be satisfied before the company can sell more bonds. Bonds may also be issued in exchange or substitution for outstanding bonds, previously retired bonds, and bonds otherwise acquired. A further earnings test found often in utility indentures requires interest charges to be covered by pretax income available for interest charges of at least a specified number of times.

Mortgage bonds go by many different names such as first mortgage bonds or first refunding mortgage bonds. There are instances when a company might have two or more layers of mortgage debt outstanding with different priorities. This situation usually occurs because the companies cannot issue additional first mortgage debt (or the equivalent) under the existing indentures. Often, this secondary debt level is called general and refunding mortgage bonds. In reality, this is mostly second mortgage debt.

Other Mortgage Debt Nonutility companies do not offer much mortgage debt nowadays; the preferred form of debt financing is unsecured. In the past, railroad operating companies were frequent issuers of mortgage debt. In the broad classification of industrial companies, only a few have first mortgage bonds outstanding. While electric utility mortgage bonds generally have a lien on practically all of the company's property, mortgage debt of industrials has more limited liens. Mortgages may also contain maintenance and repair provisions, earnings tests for the issuance of additional debt, release and substitution of property clauses, and limited after-acquired property provisions. In some cases, shares of subsidiaries might also be pledged as part of the lien.

Some mortgage bonds are secured by a lien on a specific property rather than on most of a company's property, as in the case of an electric utility.

Other Secured Debt Debt can be secured by many different assets. For example, a debt issue can be secured by a first-priority lien on substantially all of the issuer's real property, machinery, and equipment, and by a second-priority lien on its inventory, accounts receivables, and intangibles.

Collateral trust debentures, bonds, and notes are secured by financial assets such as cash, receivables, other notes, debentures, or bonds, and not by real property. Collateral trust notes and debentures have been issued by companies engaged in vehicle leasing. Protective covenants for these collateralized issues may include limitations on the equipment debt of subsidiaries, on the consolidated debt of the issuer and its subsidiaries, on dividend payments by the issuer and its subsidiaries, and on the creation of liens and purchase money mortgages, among other things. The eligible collateral is held by a trustee and periodically marked to market to ensure that the market value has a liquidation value in excess of the amount needed to repay the entire outstanding bonds and accrued interest. If the collateral is insufficient, the issuer must, within several days, bring the value of the collateral up to the required amount. If the issuer is unable to do so, the trustee would then sell collateral and redeem bonds. Another collateralized structure allows for the defeasance or "mandatory collateral substitution," which provides the investor assurance that it will continue to receive the same interest payments until maturity. Instead of redeeming the bonds with the proceeds of the collateral sale, the proceeds are used to purchase a portfolio of U.S. government securities in such an amount that the cash flow is sufficient to meet the principal and interest payments on the mortgage-backed bond. Because of the structure of these issues, the rating agencies have assigned their highest rating (triple A) to them. The rating is based on the strength of the collateral and the issues' structure, not on the issuers' credit standing.

Equipment Trust Financing Railroads and airlines have financed much of their rolling stock and aircraft with secured debt. The securities go by various names such as equipment trust certificates (ETCs), in the case of railroads, and secured equipment certificates, guaranteed loan certificates, and loan certificates in the case of airlines. We look at railroad equipment trust financing first for two reasons: (1) the financing of railway equipment under the format in general public use today goes back to the late nineteenth century, and (2) it has had a superb record of safety of principal and timely payment of interest, more traditionally known as dividends. Railroads probably comprise the largest and oldest group of issuers of secured equipment financing.

Probably the earliest instance in U.S. financial history in which a company bought equipment under a conditional sales agreement (CSA) was in 1845 when the Schuylkill Navigation Company purchased some barges. Over the years, secured equipment financing proved to be an attractive way for railroads—both good and bad credits—to raise the capital necessary to finance rolling stock. Various types of instruments were devised—equipment bonds (known as the New York Plan), conditional sales agreements (also known as the New York CSA), lease arrangements, and the Philadelphia Plan equipment trust certificate. The New York Plan equipment bond has not been used since the 1930s. The Philadelphia Plan ETC is the form used for most, if not all, public financings in today's market.

The ratings for ETCs are higher than on the same company's mortgage debt or other public debt securities. This is due primarily to the collateral value of the equipment, its superior standing in bankruptcy compared with other claims, and the instrument's generally self-liquidating nature. The railroad's actual credit worthiness may mean less for some equipment trust investors than for investors in other rail securities or, for that matter, other corporate paper. However, that is not to say that financial analysis of the issuer should be ignored.

ETCs are issued under agreement that provide a trust for the benefit of the investors. Each certificate represents an interest in the trust equal to its principal amount and bears the railroad's unconditional guarantee of prompt payment, when due, of the principal and dividends (the term dividends is used because the payments represent income from a trust and not interest on a loan). The trustee holds the title to the equipment, which when the certificates are retired, passes to, or vests in, the railroad, but the railroad has all other ownership rights. It can take the depreciation and can utilize any tax benefits on the subject equipment. The railroad agrees to pay the trustee sufficient rental for the principal payments and the dividends due on the certificates, together with expenses of the trust and certain other charges. The railroad uses the equipment in its normal operations and is required to maintain it in good operating order and repair (at its own expense). If the equipment is destroyed, lost, or becomes worn out or unsuitable for use (that is, suffers a "casualty occurrence"), the company must substitute the fair market value of that equipment in the form of either cash or additional equipment. Cash may be used to acquire additional equipment unless the agreement states otherwise. The trust equipment is usually clearly marked that it is not the railroad's property.

Immediately after the issuance of an ETC, the railroad has an equity interest in the equipment that provides a margin of safety for the investor. Normally, the ETC investor finances no more than 80% of the cost of the equipment and the railroad the remaining 20%. Although modern equipment is longer lived than that of many years ago, the ETC's length of maturity is still generally the standard 15 years (there are some exceptions noted as follows).

The structure of the financing usually provides for periodic retirement of the outstanding certificates. The most common form of ETC is the serial variety. It is usually issued in 15 equal maturities, each one coming due annually in years 1 through 15. There are single-maturity (or "bullet-maturity") ETCs. There are also sinking-fund equipment trust certificates where the ETCs are retired through the operation of a normal sinking fund, one-fifteenth of the original amount issued per year.

The standing of railroad or common carrier ETCs in bankruptcy is of vital importance to the investor. Because the equipment is needed for operations, the bankrupt railroad's management will more than likely reaffirm the lease of the equipment because, without rolling stock, it is out of business. Cases of disaffirmation of equipment obligations are very rare indeed, but if equipment debt were to be disaffirmed, the trustee could repossess and then try to release or sell it to others. Any deficiency due the equipment debtholders would still be an unsecured claim against the bankrupt railway company. Standard-gauge, nonspecialized equipment should not be difficult to release to another railroad.

The Bankruptcy Reform Act of 1978 provides specifically that railroads be reorganized, not liquidated, and subchapter IV of Chapter 11 grants them special treatment and protection. It protects the rights of the equipment lenders while giving the trustee the chance to cure any defaults. Railroad bankruptcies usually do not occur overnight but creep up gradually as the result of steady deterioration over the years. New equipment financing capability becomes restrained. The outstanding equipment debt at the time of bankruptcy often is not substantial and usually has a good equity cushion built in.

Airline equipment debt has some of the special status that is held by railroad equipment trust certificates. Of course, it is much more recent, having developed since the end of World War II. Many airlines have had to resort to secured equipment financing, especially since the early 1970s. Like railroad equipment obligations, certain equipment debt of certified airlines, under Section 1110 of the Bankruptcy Reform Act of 1978, is not subject to Sections 362 and 363 of the Act, namely the automatic stay and the power of the court to prohibit the repossession of the equipment. The creditor must be a lessor, a conditional vendor, or hold a purchase money security interest with respect to the aircraft and related equipment. The secured equipment must be new, not used. Of course, it gives the airline 60 days in which to decide to cancel the lease or debt and to return the equipment to the trustee. If the reorganization trustee decides to reaffirm the lease in order to continue using the equipment, it must perform or assume the debtor's obligations, which become due or payable after that date, and cure all existing defaults other than those resulting solely from the financial condition, bankruptcy, insolvency, or reorganization of the airline. Payments resume including those that were due during the delayed period. Thus, the creditor will get either the payments due according to the terms of the contract or the equipment.

The equipment is an important factor. If the airplanes are of recent vintage, well-maintained, fuel efficient, and relatively economical to operate, it is more likely that a company in distress and seeking to reorganize would assume the equipment lease. However, if the outlook for reorganization appears dim from the outset and the airplanes are older and less economical, the airline could very well disaffirm the lease. In this case, releasing the aircraft or selling it at rents and prices sufficient to continue the original payments and terms to the security holders might be difficult. Of course, the resale market for aircraft is on a plane-by-plane basis and highly subject to supply and demand factors. Multimillion-dollar airplanes have a somewhat more limited market than do boxcars and hopper cars.

The lease agreement required the airline to pay a rental sufficient to cover the interest, amortization of principal, and a return to the equity participant. The airline was responsible for maintaining and operating the aircraft, as well as providing for adequate insurance. It must also keep the equipment registered and record the ETC and lease under the Federal Aviation Act of 1958.

In the event of a loss or destruction of the equipment, the company may substitute similar equipment of equal value and in as good operating condition and repair and as airworthy as that which was lost or destroyed. It also has the option to redeem the outstanding certificates with the insurance proceeds.

An important point to consider is the equity owner. If the airline runs into financial difficulty and fails to make the required payments, the owner may step in and make the rental payment in order to protect its investment. The carrier's failure to make a basic rental payment within the stipulated grace period is an act of default but is cured if the owner makes payment. Thus, a strong owner lends support to the financing, and a weak one little.

An investor should not be misled by the title of the issue just because the words secured or equipment trust appear. Investors should look at the collateral and its estimated value based on the studies of recognized appraisers compared with the amount of equipment debt outstanding. Is the equipment new or used? Do the creditors benefit from Section 1110 of the Bankruptcy Reform Act? Because the equipment is a depreciable item and subject to wear, tear, and obsolescence, a sinking fund starting within several years of the initial offering date should be provided if the debt is not issued in serial form. Of course, the ownership of the aircraft is important as just noted. Obviously, one must review the obligor's financials because the investor's first line of defense depends on the airline's ability to service the lease rental payments.

Unsecured Debt

We have discussed many of the features common to secured debt. Take away the collateral and we have unsecured debt.

Unsecured debt, like secured debt, comes in several different layers or levels of claim against the corporation's assets. But in the case of unsecured debt, the nomenclature attached to the debt issues sounds less substantial. For example, "general and refunding mortgage bonds" may sound more important than "subordinated debentures," even though both are basically second claims on the issuing corporation. In addition to the normal debentures and notes, there are junior issues representing the secondary and tertiary levels of the capital structure. The difference in a high-grade issuer may be considered insignificant as long as the issuer maintains its quality. But in cases of financial distress, the junior issues usually fare worse than the senior issues. Only in cases of very well-protected junior issues will investors come out whole—in which case, so would the holders of senior indebtedness. Thus, many investors are more than willing to take junior debt of high-grade companies; the minor additional risk, compared to that of the senior debt of lower-rated issuers, may well be worth the incremental income.

Credit Enhancements

Some debt issuers have other companies guarantee their debt. This is normally done when a subsidiary issues debt and the investors want the added protection of a third-party guarantee. The use of guarantees makes it easier and more convenient to finance special projects and affiliates, although guarantees are extended to operating company debt.

There are also other types of third-party credit enhancements. Some captive finance subsidiaries of industrial companies enter into agreements requiring them to maintain fixed charge coverage at such a level so that the securities meet the eligibility standards for investment by insurance companies under New York State law. The required coverage levels are maintained by adjusting the prices at which the finance company buys its receivables from the parent company or through special payments from the parent company. These supplemental income maintenance agreements, while usually not part of indentures, are very important considerations for bond buyers.

Another type of support can call for an agreement between the company and its parent that stipulates that the parent (1) agrees to cause the subsidiary to maintain a positive tangible net worth in accordance with generally accepted accounting principles; (2) will provide the necessary funds to pay debt service if the subsidiary is unable to meet the obligations when due; and (3) shall own, directly or indirectly, all of the outstanding voting capital stock of the subsidiary throughout the life of the support agreement. In addition, in case of a default by the parent in meeting its obligations under the default agreement, or in the case of default by the subsidiary in the payment of principal and/or interest, the holders of the securities or the trustee may proceed directly against the parent.

Another credit-enhancing feature is the letter of credit (LOC) issued by a bank. An LOC requires the bank to make payments to the trustee when requested so that monies will be available for the bond issuer to meet its interest and principal payments when due. Thus, the credit of the bank under the LOC is substituted for that of the debt issuer.

Insurance companies also lend their credit standing to corporate debt, both new issues and outstanding secondary market issues. While a guarantee or other type of credit enhancement may add some measure of protection to a debtholder, an analysis of both the issuer and the guarantor should be performed. In many cases, only the latter is needed if the issuer is merely a financing conduit without any operations of its own. However, if both concerns are operating companies, it may very well be necessary to analyze both because the timely payment of principal and interest ultimately will depend on the stronger party. A downgrade of the enhancer's claims-paying ability reduces the value of the bonds.

Negative Pledge Clause

One of the important protective provisions for unsecured debtholders is the negative pledge clause. This provision, found in most senior unsecured debt issues and a few subordinated issues, prohibits a company from creating or assuming any lien to secure a debt issue without equally securing the subject debt issue(s) (with certain exceptions). Its inclusion in the indenture is designed to prevent other creditors from obtaining a senior position at the expense of existing creditors; however, it is not intended to prevent other creditors from sharing in the position of debenture holders. It is not necessary to have such a clause unless the issuer runs into trouble. But like insurance, it is not needed until the time that no one wants arrives.

There are provisions that may result in all or a portion of a bond issue being paid off prior to the stated maturity date. These include (1) call and refund provisions and (2) sinking-fund provisions. We describe both below.

Call and Refund Provisions

An important question in negotiating the terms of a new bond issue is whether the issuer shall have the right to redeem the entire amount of bonds outstanding on a date before maturity. Issuers generally want this right because they recognize that at some time in the future the general level of interest rates may fall sufficiently below the issue's coupon rate that redeeming the issue and replacing it with another issue with a lower coupon rate would be attractive. This right is a disadvantage to the bondholder.

A company wanting to retire a debt issue prior to maturity usually must pay a premium over the par value for the privilege. The initial call premium on long-term debt traditionally has been the interest coupon plus par or the initial reoffering price (in some cases it is the higher of the two). Thus, a 30-year bond initially priced at 100 with a 7% coupon may have a call price of 107% for the first year, scaled down in relatively equal amounts to par starting in year 21 to maturity.

Instead of a specified fixed premium that must be paid by the issuer if the bond is called, a bond may have a make-whole premium provision, also called a yield-maintenance premium provision. The provision specifies a formula for determining the premium that the issuer must pay to call an issue and is such that the amount of the premium, when added to the principal amount and reinvested at the redemption date in U.S. Treasury securities having the same remaining life, would provide a yield equal to the original yield. The premium plus the principal at which the issue is called is referred to as the make-whole redemption price. The purpose of the make-whole premium is to protect the yield of those investors who purchased the issue at issuance.

If a bond issue does not have any protection against early call, it is said to be a currently callable issue. But most new bond issues, even if currently callable, usually have some restrictions against certain types of early redemption. The most common restriction is that prohibiting the refunding of the bonds for a certain number of years. Bonds that are noncallable for the issue's life are more common than bonds that are nonrefundable for life but otherwise callable.

Bonds are sometimes referred to as noncallable and non-refundable with the terms used interchangeably. However, technically they have different meanings. Call protection is much more absolute than refunding protection. Although there may be certain exceptions to absolute or complete call protection in some cases (such as sinking funds and the redemption of debt under certain mandatory provisions), it still provides greater assurance against premature and unwanted redemption than does refunding protection. Refunding prohibition merely prevents redemption only from certain sources, namely the proceeds of other debt issues sold at a lower cost of money. The holder is protected only if interest rates decline, and the borrower can obtain lower-cost money to pay off the debt.

A number of industrial companies issued long-term debt with extended call protection, not refunding protection. A number are noncallable for the issue's life. For such issues the prospectus expressly prohibits redemption prior to maturity. These noncallable-for-life issues are referred to as bullet bonds.

Bonds can be called in whole (the entire issue) or in part (only a portion). When less than the entire issue is called, the specific bonds to be called are selected randomly or on a pro rata basis.

Sinking-Fund Provision

The indenture may include a sinking-fund provision. This provision allows for a debt's periodic retirement or amortization over its life span. This provision for repayment of corporate debt may be designed to liquidate all of a bond issue by the maturity date, or it may be arranged to pay only a part of the total by the end of the term. If only a part is paid, the remainder is called a balloon maturity. The purpose of the sinking-fund provision is to reduce credit risk.

A variety of sinking-fund types are found in publicly issued corporate debt. The most common is the mandatory sinking fund, requiring the periodic redemption of a certain amount of a specific debt issue. A mandatory sinking fund specifies that the issuer may satisfy the provision in whole or in part, by (1) delivering bonds acquired through open-market purchases or other means or (2) paying cash to the trustee who will call bonds for redemption at 100. This type is found in most longer-term industrial issues and some electric utility bonds.

Another type of sinking-fund provision that is most prevalent in electric utility company issues is the non-mandatory sinking-fund provision. This provision allows the issuer to satisfy the sinking-fund provision by the utilization of unfunded property additions or improvements at a certain percentage of their cost. This third alternative is referred to as a property credit. Property credits so utilized cannot be further employed under the mortgage.

A corporate sinking-fund provision may be a specific sinking-fund provision or a nonspecific sinking-fund provision. A specific sinking fund applies to just the named issue. A nonspecific sinking fund, also known as a funnel, tunnel, blanket, or aggregate sinking fund, is based on the outstanding amount of a company's total bonded indebtedness. In most cases, the redemption price for bonds called under the funnel sinking fund is par.

Usually, the periodic payments required for sinking-fund purposes will be the same for each period. A few indentures might permit variable periodic payments, where payments change according to certain prescribed conditions set forth in the indenture. Many corporate bond indentures include a provision that grants the issuer the option to retire more than the amount stipulated for sinking-fund retirement. This is referred to as an accelerated sinking-fund provision.

Usually, the sinking-fund call price is the par value if the bonds were originally sold at par. When issued at a price in excess of par, the call price generally starts at the issuance price and scales down to par as the issue approaches maturity.

Speculative-grade bonds are those rated below investment grade by the rating agencies (that is, BBB— and lower by Standard & Poor's and Fitch Ratings and Baa3 and lower by Moody's). They may also be unrated, but not all unrated debt is speculative. They are also known as high-yield bonds and junk bonds.

Types of Issuers

Several types of issuers fall into the less-than-investment-grade high-yield category. These include:

Original issuers may be young, growing corporations lacking the stronger balance sheet and income statement profile of many established corporations, but often with lots of promise. Also called venture capital situations or growth or emerging market companies, the debt is often sold with a story projecting future financial strength. From this we get the term "story bond." There are also the established operating firms with financials neither measuring up to the strengths of investment-grade corporations nor possessing the weaknesses of companies on the verge of bankruptcy. Subordinated debt of investment-grade issuers may be included here. A bond rated at the bottom rung of the investment-grade category (Baa and BBB) or at the top end of the speculative-grade category (Ba and BB) is known as a "businessman's risk."

Fallen angels are formerly companies with investment-grade-rated debt that have come upon hard times with deteriorating balance sheet and income statement financial parameters. (Companies that have been upgraded to investment-grade status are referred to as rising stars.) They may be in default or near bankruptcy. In these cases, investors are interested in the workout value of the debt in a reorganization or liquidation, whether within or without the bankruptcy courts. Some refer to these issues as "special situations." Over the years they have fallen on hard times; some have recovered and others have not.

General Motors Corporation and Ford Motor Company are examples of fallen angels. From 1954 to 1981, General Motors Corp. was rated AAA by S&P; Ford Motor Co. was rated AA by S&P from 1971 to 1980. In August 2005, Moody's lowered the rating on both automakers to junk bond status.

Restructurings and leveraged buyouts are companies that have deliberately increased their debt burden with a view toward maximizing shareholder value. The shareholders may be the existing public group to which the company pays a special extraordinary dividend, with the funds coming from borrowings and the sale of assets. Cash is paid out, net worth decreased and leverage increased, and ratings drop on existing debt. Newly issued debt gets junk bond status because of the company's weakened financial condition.

In a leveraged buyout (LBO), a new and private shareholder group owns and manages the company. The debt issue's purpose may be to retire other debt from commercial and investment banks and institutional investors incurred to finance the LBO. The debt to be retired is called bridge financing because it provides a bridge between the initial LBO activity and the more permanent financing.

Unique Features of Some Issues

Often actions that are taken by management that result in the assignment of a non-investment-grade bond rating result in a heavy corporate interest payment burden. This places severe cash flow constraints on the firm. To reduce this burden, firms involved with heavy debt burdens have issued bonds with deferred coupon structures that permit the issuer to avoid using cash to make interest payments for a period of 3 to 7 years. There are three types of deferred coupon structures:

Deferred-interest bonds are the most common type of deferred coupon structure. These bonds sell at a deep discount and do not pay interest for an initial period, typically from 3 to 7 years. (Because no interest is paid for the initial period, these bonds are sometimes referred to as zero-coupon bonds.) Step-up bonds do pay coupon interest, but the coupon rate is low for an initial period and then increases ("steps up") to a higher coupon rate. Finally, payment-in-kind (PIK) bonds give the issuer an option to pay cash at a coupon payment date or give the bondholder a similar bond (that is, a bond with the same coupon rate and a par value equal to the amount of the coupon payment that would have been paid). The period during which the issuer can make this choice varies from 5 to 10 years.

An extendable reset bond structure allows the issuer to reset the coupon rate so that the bond will trade at a predetermined price. The coupon rate may reset annually or even more frequently, or reset only one time over the life of the bond. Generally, the coupon rate at the reset date will be the average of rates suggested by two investment banking firms. The new rate will then reflect (1) the level of interest rates at the reset date and (2) the credit spread the market wants on the issue at the reset date. Notice the difference between an extendible reset bond and a floating-rate issue. In a floating-rate issue, the coupon rate resets according to a fixed spread over the reference rate, with the index spread specified in the indenture. The amount of the index spread reflects market conditions at the time the issue is offered. The coupon rate on an extendible reset bond, in contrast, is reset based on market conditions (as suggested by several investment banking firms) at the time of the reset date. Moreover, the new coupon rate reflects the new level of interest rates and the new spread that investors seek. The advantage to investors of extendible reset bonds is that the coupon rate will reset to the market rate—both the level of interest rates and the credit spread—in principle keeping the issue at par value.

Historically, the trading of corporate bond trading is done in the over-the-counter (OTC) market conducted via telephone and based on broker-dealer trading desks. In this market, broker-dealer trading desks take principal positions in corporate bonds in order to fulfill buy and sell orders of their customers. There has been a transition away from this traditional form of bond trading and toward electronic trading.

In 2002 the National Association of Securities Dealers (NASD) instituted a mandatory reporting of OTC secondary market transactions for corporate bonds that met specific criteria. The reporting system, the Trade Reporting and Compliance Engine (TRACE), requires that all NASD broker/dealers report transactions in corporate bonds to TRACE. At the end of each trading day, market aggregate statistics are published on corporate bond market activity. End of day recap information provided includes (1) the number of securities and total par amount traded, (2) advances, declines, and 52-week highs and lows, and (3) the 10 most active investment-grade, high-yield, and convertible bonds for the day.

Electronic Trading of Corporate Bonds

There are four major advantages of electronic trading over traditional corporate bond trading in the OTC market (see Jones and Fabozzi, 2005):

As an example of the last advantage, a portfolio manager can load buy/sell orders on a web site, trade from these orders, and then clear these orders.

In its 2006 survey of electronic trading transaction systems, the Securities Industry and Financial Markets Association (SIFMA) found that there was a rapid increase in the adoption of electronic execution not only in the United States but globally. The SIFMA categorizes electronic trading systems based on (1) who the participants are and the way in which they conduct trades with each other and (2) the methodology or technology employed by participants for price discovery and trade execution.

The first classification includes two types of platforms:

Interdealer platforms allow dealers to execute transactions electronically with other dealers via the anonymous services of "brokers' brokers." The customers of dealers are not involved in interdealer systems.

Dealer-to-customer platforms support trading between customers and broker-dealers. There are two types of dealer-to-customer platforms. Multiple dealer-to-customer platforms typically display to customers the best bid or offer price of those posted by all dealers. The participating dealer usually acts as the principal in the transaction. Single dealer-to-customer platforms permit investors to execute transactions directly with the specific dealer desired.

In addition to electronic trading platforms to support trading in the secondary market just described, there are new issue platforms that support the sales of newly issued corporate bonds to either institutional investors or broker-dealers or both.

The systems used for price discovery and trade execution include:

Request-for-quotes systems permit buy-side customers to request executable quotes from broker-dealers with whom they have a customer relationship. These systems are used in multiple dealer-to-customer platforms. In an order-driven system, a participant can enter quotations into central order book.

Securities privately placed are exempt from registration with the SEC because they are issued in transactions that do not involve a public offering. The private-placement market has undergone a major change since the adoption of SEC Rule 144A in 1990, which allows the trading of privately placed securities among qualified institutional buyers.

Not all private placements are Rule 144A private placement. Consequently, the private-placement market can be divided into two sectors. First is the traditional private-placement market, which includes non-144A securities. Second is the market for 144A securities.

Rule 144A private placements are now underwritten by investment bankers on a firm commitment basis, just as with publicly issued bonds. The features in these issues are similar to those of publicly issued bonds. For example, the restrictions imposed on the borrower are less onerous than for traditional private-placement issues. For underwritten issues, the size of the offering is comparable to that of publicly offered bonds.

Unlike publicly issued bonds, the issuers of privately placed issues tend to be less well known. In this way, the private-placement market shares a common characteristic with the bank loan market that we will discuss later in this chapter. Borrowers in the publicly issued bond market are typically large corporations. Issuers of privately placed bonds tend to be medium-sized corporations. Those corporations that borrow from banks tend to be small corporations.

Although the liquidity of issues has increased since Rule 144A became effective, it is still not comparable to that of publicly offered issues. Yields on privately placed debt issues are still higher than those on publicly offered bonds. However, one market observer reports that the premium that must be paid by borrowers in the private placement market has decreased as investment banking firms have committed capital and trading personnel to making markets for securities issued under Rule 144A.

MTN differ from corporate bonds in the manner in which they are distributed to investors when they are initially sold. Although some investment-grade corporate bond issues are sold on a best-efforts basis, typically they are underwritten by investment bankers. Traditionally, MTNs have been distributed on a best-efforts basis by either an investment banking firm or other broker/dealers acting as agents. Another difference between corporate bonds and MTNs when they are offered is that MTNs are usually sold in relatively small amounts on a continuous or an intermittent basis, whereas corporate bonds are sold in large, discrete offerings.

A corporation that wants an MTN program will file a shell registration with the SEC for the offering of securities. Although the SEC registration for MTN offerings is between $100 and $1 billion, after the total is sold, the issuer can file another shelf registration. The registration will include a list of the investment banking firms, usually two to four, that the corporation has arranged to act as agents to distribute the MTNs.

The issuer then posts rates over a range of maturities: for example, 9 months to 1 year, 1 year to 18 months, 18 months to 2 years, and annually thereafter. This is called the rate offering schedule. Usually, an issuer will post rates as a spread over a Treasury security of comparable maturity. Rates are not posted for maturity ranges that the issuer does not desire to sell.

The agents will then make the offering rate schedule available to their investor base interested in MTNs. An investor who is interested in the offering will contact the agent. In turn, the agent contacts the issuer to confirm the terms of the transaction. Because the maturity range in the offering rate schedule does not specify a specific maturity date, the investor can choose the final maturity subject to approval by the issuer. The minimum size that an investor can purchase of an MTN offering typically ranges from $1 million to $25 million.

The rate offering schedule can be changed at any time by the issuer either in response to changing market conditions or because the issuer has raised the desired amount of funds at a given maturity. In the latter case, the issuer can either not post a rate for that maturity range or lower the rate.

Some issues of MTNs are coupled with transactions in the derivative markets (options, futures/forwards, swaps, caps, and floors) in order to create debt obligations with more risk-return features unavailable in the corporate bond market. Specifically, an issue can be floating-rate over all or part of the life of the security, and the coupon reset formula can be based on a benchmark interest rate, equity index or individual stock price, a foreign exchange rate, or a commodity index. Inverse floaters (that is, floaters whose coupon moves in the opposite direction of the change of a reference interest rate) are created in the structured MTN market. MTNs can have various embedded options included.

MTNs created when the issuer simultaneously transacts in the derivative markets are called structured notes. The most common derivative instrument used in creating structured notes is a swap. By using the derivative markets in combination with an offering, borrowers are able to create investment vehicles that are more customized for institutional investors to satisfy their investment objectives. Moreover, it allows institutional investors who are restricted to investing in investment-grade debt issues the opportunity to participate in other asset classes to make a market play. For example, an investor who buys an MTN whose coupon rate is tied to the performance of the S&P 500 is participating in the equity market without owning common stock. If the coupon rate is tied to a foreign stock index, the investor is participating in the equity market of a foreign country without owning foreign common stock. In exchange for creating a structured note, borrowers can reduce their funding costs.

In a typical offering of a corporate bond, the sales force of the underwriting firm will solicit interest in the offering from its customer base. That is, the sales force will make an inquiry. In the structured note market, the process is often quite different. Because of the small size of an offering and the flexibility to customize the offering in the swap market, investors can approach an issuer through its agent about designing a security for their needs. This process of customers inquiring of issuers or their agents to design a security is called a reverse inquiry. Transactions that originate from reverse inquiries account for a significant share of MTN transactions.

Payments made to preferred stockholders are treated as a distribution of earnings. Hence, unlike interest payments that are treated as business expenses by a corporation and therefore tax deductible in determining earnings, preferred stock dividend payments are not. While this raises the after-tax cost of funds if a corporation issues preferred stock rather than issuing debt or borrowers via bank loans, there is a provision in the tax code that makes the holding of preferred stock more appealing to corporate treasurers of other corporations and thereby allows a corporation to issue preferred stock at a reduced cost. This provision is the intercorporate tax dividend exclusion which exempts 80% of qualified dividends from federal income taxation if the recipient is a qualified corporation. For example, if Corporation A owns the preferred stock of Corporation B, for each $1 million of dividends received by A, only $200,000 will be taxed at A's marginal tax rate. The purpose of this provision is to mitigate the effect of double taxation of corporate earnings. This tax provision is the chief reason that the major buyers of preferred stock are corporations who are seeking tax-advantaged investments.