Investing in corporate bonds has proved to be an attractive investment opportunity over the last two decades, yielding high returns for keen investors.
The bond industry is a multi-trillion dollar market where people invest in all types of debt which can hold good and bad characteristics.
Now let’s imagine you and your friend have both invested £100,000 each into a corporate bond.
The company that you have invested in has had to change the way that it operates during the pandemic.
In this particular scenario, the company has not been able to keep up the costs of running the business and has to declare bankruptcy.
You receive your money back, but your friend does not.
You both invested into the same company, so what has happened here?
Luckily for you, the WiseAlpha Bond Academy is here to help!
Firstly, you should know that there are two main types of debt.
Secured debt and unsecured debt
Senior secured debt has identifiable assets that can be used as collateral in the event of a default.
Let’s say a company pledged property against a borrowing as collateral.
If they cannot afford to pay back the debt, the property would be sold and the proceeds they receive from the sold property would be used to pay back the debt.
On the other hand, there is senior unsecured debt.
This is debt that has no assets pledged as collateral.
Therefore, you have no proceeds to pay back the debt.
In the above scenario, your friend would have invested in an unsecured debt.
You would have invested in a secured debt.
Side note: you can also have hybrid debt which essentially has characteristics of both equity and debt – we’ll go into this another time.
Senior? Is there a junior as well?
Yes – the senior is a reference to the fact that you can have “junior” debt.
Junior debt is second in line to receive any funds recovered following a bankruptcy.
Second in line? What happens after a bankruptcy?
When a company enters bankruptcy, if applicable, assets are liquidated.
The proceeds of such can be provided to bondholders, shareholders, creditors, suppliers, acquirers – the list goes on.
In the event of a default, a secured bond investment holds greater value than an unsecured bond investment because a company liquidates the pledged asset to pay the debt.
Risk and Reward
Investors’ position within a company’s capital structure determines the order in which they will receive proceeds from bankruptcy proceedings.
Investing in a secured debt is a less risky investment opportunity than an unsecured debt because the company has pledged an asset as collateral.
Therefore, in the event of a default, secured bondholders would receive their money back before unsecured bondholders.
It is important for an investor to look at where they sit in a company’s capital structure to better understand the level of risk associated with making a particular investment.
What about shareholders?
Unfortunately, as shareholders value within the company sits only as equity, they are at risk for significant losses.
If the proceeds from liquidating a company’s assets are not sufficient to cover all investors, shareholders are usually the last people to be paid out.
Investment security ranking?
In a nutshell, the order is:
1) Bank fixed term bonds
2) Senior secured bonds
3) Senior unsecured bonds
4) Subordinated high yield bonds
5) Hybrid and perpetuals
Is the order different in terms of which one loses value first?
The order of application of losses (i.e. which loses value first) is:
2) Hybrid and perpetuals
3) Subordinated high yield bonds
4) Senior unsecured bonds
5) Senior secured bonds
6) Bank fixed term bonds
What are the differences between bonds and equities?
An easy way to think about this is to see company shareholders as its owners and the company’s bondholders as people it has borrowed money from.
Technically speaking, shareholders are borrowing money from bondholders.
Unlike bonds, equities offer less clarity about future returns because they do not have coupon payment dates where you have an expectation of your capital being returned.
Equity managers also have no obligation to pay dividends and there is no promise that your capital will be returned at a particular maturity date.
What’s a dividend?
When a company receives its annual profits, it can choose to pay its shareholders in the form of a dividend.
This dividend payment is divided among all shareholders.
Are the bond market and stock market similar?
They hold similar characteristics in the sense that the price of bonds can go up and down (we will discuss this in another blog).
However, equities are more volatile than bonds which means their prices vary more.
Which one should I invest in?
The answer to this question really depends on your personal circumstance, but in short – both.
There are several benefits to owning both equities and bonds as part of a diversified portfolio.
It is often said that you should “own your age in bonds”.
Our next blog post…
We will be discussing what causes bond prices to move.
All of this useful information is accessible on the WiseAlpha Bond Academy so please visit it and start learning about bonds.
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