2.3 Corporate Bonds

Secured vs. Unsecured

Corporate bonds raise capital for companies, and the first question is whether the bond is backed by collateral.

Secured bonds pledge specific assets that bondholders may claim on default; the collateral lowers risk and therefore the yield.

Debentures are unsecured — backed only by the issuer's general credit and full faith and credit, no specific asset. On the exam "debenture" = "unsecured bond," and because there is no collateral they yield more than secured bonds.

Subordinated debentures rank below regular debentures and are paid only after senior unsecured creditors are made whole. Income (adjustment) bonds pay interest only if the issuer has sufficient earnings declared by the board — the riskiest corporate structure and usually issued in reorganizations.

Liquidation Priority

In bankruptcy, claims are paid in a strict order. Memorize it:

1. Secured creditors (e.g., mortgage bondholders)
2. General/senior unsecured creditors (debenture holders)
3. Subordinated debt holders
4. Preferred stockholders
5. Common stockholders (last)

Trap: unpaid wages, taxes, and administrative/legal costs of the bankruptcy are actually settled before any security holders — but among the securities, bondholders always precede stockholders.

Convertible Bonds

A convertible bond can be exchanged for a fixed number of common shares at the holder's option.

Worked example: A $1,000 convertible with a 25:1 ratio has a conversion price of $1,000 ÷ 25 = $40. If the stock trades at $50, conversion value = 25 × $50 = $1,250, so the bond should trade at or above parity. To find a bond's parity price from a stock price, multiply the ratio by the stock price; to find the stock parity from a bond price, divide the bond price by the ratio.

Convertibles pay lower coupons than comparable straight bonds because the equity option adds value. They offer a bond floor (downside protection) plus upside participation, and anti-dilution provisions adjust the ratio for stock splits and stock dividends so the holder is not diluted.

Watch the difference between a forced conversion and a voluntary one. When the underlying stock rises well above the conversion price, the bond trades on parity with the stock and behaves like equity; if the issuer also has a call provision, it can force conversion by calling the bond at a price below the conversion value, leaving holders little choice but to convert. A common exam calculation asks for the parity price of the stock: divide the bond's market price by the conversion ratio.

For a bond at $1,200 with a 25:1 ratio, parity is $1,200 ÷ 25 = $48 per share, so the stock must trade above $48 for conversion to add value at that bond price.

High-Yield (Junk) Bonds and Credit Ratings

Credit ratings estimate default probability. Bonds rated BBB-/Baa3 and above are investment grade; BB+/Ba1 and below are high-yield (junk) — speculative, higher-yielding, more volatile, and more correlated with stocks in a downturn.

Many institutions (pensions, insurers) are restricted to investment-grade paper, so a downgrade from BBB- to BB+ (a "fallen angel") can force selling and push the price down sharply — a frequently tested scenario.

A rep should never describe a junk bond as "safe" or imply that its high yield comes without commensurate risk; doing so would violate FINRA's communications and suitability rules. The extra yield is precisely compensation for a meaningfully higher chance of default, and high-yield prices tend to fall alongside stocks during recessions rather than providing the diversification a conservative investor expects from bonds.

Trading and Transparency

Corporate bond trades are reported through FINRA's TRACE (Trade Reporting and Compliance Engine) system, which publishes execution prices to improve transparency in the over-the-counter bond market. Unlike exchange-listed stocks, most corporate bonds trade dealer-to-dealer, so prices are negotiated and confirmations must disclose any markup or markdown. The exam expects you to know that bond pricing is far less transparent than equity pricing, that TRACE exists to narrow that gap, and that the representative's confirmation obligations include disclosing yield, capacity (agent versus principal), and compensation.

Bonds are quoted as a percentage of par in eighths historically, though most systems now display decimals.

On the Exam

Expect: distinguishing secured bonds from debentures, ordering claims in a liquidation (bondholders before stockholders), convertible math (conversion price, conversion value, parity), and the BBB-/Baa3 investment-grade cutoff that separates investment grade from junk.