Outline bond features including collateral, interest rate, maturity and issuer.
The idea
Collateral determines security and seniority. Secured bonds, such as mortgage bonds, collateral trust bonds and equipment trust certificates, are backed by specific assets. Debentures are unsecured claims on the issuer's general credit. Subordinated debentures rank below senior debt in liquidation. Interest can be fixed, floating or zero. A floating-rate coupon is set as Coupon = reference rate + quoted spread. It is reset periodically. A zero-coupon bond is issued at a discount and pays only its face value at maturity. Maturity is the date the principal is repaid, and longer maturity generally means greater interest rate and credit exposure. The issuer type, such as industrials, utilities or financials, affects the covenants, structure and risk. In liquidation, absolute priority applies. Senior claims are paid in full before junior claims receive anything, which drives recovery.
Formulas
Coupon rate on a floating-rate bond
coupon rate = reference rate + quoted spread
- reference rate
- the market rate set at each reset date
- quoted spread
- the fixed spread over the reference rate
Reset periodically; divide the annual rate by the number of payments a year for each coupon.
A practice question
What distinguishes a debenture from a mortgage bond?
- A debenture is secured by specific property; a mortgage bond is an unsecured claim.Why not: Reverses the definitions.
- A debenture is unsecured; a mortgage bond is secured by a lien on property. - correct
- A debenture has a floating coupon; a mortgage bond has a fixed coupon.Why not: Confuses security with the coupon type; both can be fixed or floating.
- A debenture is issued only by governments; a mortgage bond only by corporations.Why not: Confuses the issuer type with the security; debentures are commonly issued by corporations.
Collateral separates secured bonds (mortgage bonds, collateral trust bonds, equipment trust certificates) from unsecured debentures that rest on the issuer's general credit.
A harder one
Which ranking of claims in liquidation, from highest to lowest priority, is correct for a corporate issuer?
- Subordinated, senior unsecured, senior secured, then equity.Why not: Reverses the seniority order; subordinated claims rank below senior debt.
- Equity, senior secured, senior unsecured, then subordinated.Why not: Puts equity first; shareholders are residual claimants and rank last.
- Senior secured, senior unsecured, subordinated, then equity. - correct
- Senior unsecured, senior secured, subordinated, then equity.Why not: Ranks unsecured above secured; secured claims rank first against their collateral.
Under absolute priority, secured claims are paid first (from their collateral), then senior unsecured, then subordinated debt, with equity last.
The hardest tier
On the issuer's default, liquidation proceeds are USD 180 million. The issuer has USD 100 million of senior secured debt fully covered by collateral worth USD 100 million, USD 120 million of senior unsecured debt and USD 80 million of subordinated debt. Under strict absolute priority, what is the recovery rate on the senior unsecured debt?
- 40.0%Why not: Shares the remaining USD 80 million pro rata between unsecured and subordinated debt, ignoring priority.
- 60.0%Why not: Shares the total USD 180 million pro rata across all debt of USD 300 million, ignoring both security and priority.
- 100.0%Why not: Applies the full USD 120 million to unsecured debt without first paying the secured debt from the proceeds.
- 66.7% - correct
After paying the secured debt USD 100 million, USD 80 million remains. Unsecured claims are USD 120 million, so recovery is 80 / 120 = 66.7%, and the subordinated debt receives nothing.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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