There are two concepts that are important to understand with respect to corporate bonds. The first is that there are classifications of bonds based on a bond's relationship to a corporation's capital structure. This is important because where a bond structure ranks in terms of its claim on a company's assets determines which investors get paid first in the event a company has trouble meeting its financial obligations.
Secured Corporates
In this ranking structure, so-called senior secured debt is at the top of the list (senior refers to its place on the payout totem pole, not the age of the debt). Secured corporate bonds are backed by collateral that the issuer may sell to repay you if the bond defaults before, or at, maturity. For example, a bond might be backed by a specific factory or piece of industrial equipment.
Junior or Subordinated Bonds
Next on the payout hierarchy is unsecured debt—debt not secured by collateral, such as unsecured bonds. Unsecured bonds, called debentures, are backed only by the promise and good credit of the bond's issuer. Within unsecured debt is a category called subordinated debt—this is debt that gets paid only after higher-ranking debt gets paid. The more junior bonds issued by a company typically are referred to as subordinated debt, because a junior bondholder's claim for repayment of the principal of such bonds is subordinated to the claims of bondholders holding the issuer's more senior debt.
| Who Gets Paid First? |
| 1. Secured (collateralized) bondholders |
| 2. Unsecured bondholders |
| 3. Holders of subordinated debt |
| 4. Preferred stockholders |
| 5. Common stockholders |
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| Junk Bond Caution Investing in below investment-grade (high yield) debt is risky: There is a real risk of default by non-investment-grade companies. Nearly 11 percent of junk bonds defaulted during the peak of the 2008-2009 recession, compared to 10.5 percent in 2001, another recession year. In contrast, the average default rate over the five-year period from 2003 to 2007 was just over 2 percent. For this reason, diversification is considered vital in junk bond investing.
The cost of buying and selling junk bonds also can be high. If you invest in high yield bond funds, be advised that expenses associated with these funds can be steep, as mutual funds pass on the cost of buying and selling to the investor. |
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However, other types of claims also may have priority over the issuer's remaining assets over the claims of all bondholders (e.g., certain supplier or customer claims). Therefore, although bondholders generally are paid prior to stockholders in a bankruptcy proceeding, this may offer little comfort if the issuer's assets are reduced to zero by other creditors that have the right to be paid before bondholders of a particular class of bonds.
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