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In the event a corporation goes out of business
or defaults on its debt, bondholders, as creditors, have priority over
stockholders in bankruptcy court. However, the order of priority among all
the vying groups of creditors depends on the specific terms of each bond,
among other factors.
One of the most important factors is whether the bond is secured or
unsecured. If a bond is secured, the issuer has pledged specific assets
(known as collateral) that can be sold, if necessary, to pay the
bondholders. If you buy a secured bond, you will ?pay? for the extra safety
by receiving a lower interest rate than you would have received on a
comparable unsecured bond.
Debenture Bonds
Most corporate bonds are debentures?that is, unsecured debt obligations
backed only by the issuer?s general credit and the capacity of its cash flow
to repay interest and principal. However, even unsecured bonds usually have
the protection of what is known as a negative pledge provision. This
requires the issuer to provide security for the unsecured bonds in the event
that it subsequently pledges its assets to secure other debt obligations.
Mortgage Bonds
These are bonds for which real estate or other physical property has been
pledged as collateral. They are mostly issued by public utilities.
There are various kinds of mortgage bonds, including the following: first,
prior, overlying, junior, second, third and so on. The designation reflects
the priority of the lien, or legal claim, you have against the specified
property. Any time you invest in mortgage bonds, you should find out how
much other debt of the issuer is secured by the same collateral and whether
the lien supporting that other debt is equal or prior to your bond?s lien.
Collateral Trust Bonds
A corporation may deposit stocks, bonds and other securities with a trustee
to back its bonds. The collateral must have a market value at the time of
issuance at least equal to the value of the bonds.
Equipment Trust Certificates
Railroads and airlines have issued this type of bond as a way to pay for new
equipment at relatively low interest rates. The title to the equipment is
held by a trustee until the loan is paid off, and the investors who buy the
certificates usually have a first claim on the equipment.
Subordinated Debentures
Debt that is subordinated, or junior, has a priority lower than that of
other debt in terms of payment (but like all bonds, it ranks ahead of
stock). Only after secured bonds and debentures are paid off can holders of
subordinated debentures be paid. In exchange for this lower status in the
event of bankruptcy, investors in subordinated securities earn a higher rate
of interest than is paid on senior securities.
Guaranteed Bonds
Another form of security is a guarantee of one corporation?s bonds by
another corporation. For example, bonds issued by a subsidiary may be
guaranteed by the parent corporation. Or bonds issued by a joint venture
between two companies may be guaranteed by both parent corporations.
Guaranteed bonds become, in effect, debentures of the guaranteeing
corporation and benefit from its presumably better credit.
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