On September 15, 2008, Lehman Brothers filed the largest bankruptcy in American history—$639 billion in assets, gone. Bondholders scrambled to understand their place in line. Secured creditors recovered most of their money. Unsecured bondholders? Not so much.
The hierarchy of corporate debt isn't just academic theory—it determines who gets paid when companies fail. This chapter covers both corporate debt structures and U.S. government securities, the backbone of the global fixed-income market.
Section 1: Corporate Debt
Characteristics of Corporate Debt
Bearer bonds were historically issued in physical form with coupons attached. No records were kept—whoever held the bond could collect interest. Today, we continue to use the term "coupon" to refer to the stated interest rate. Bearer bonds are no longer issued; all new issues are book entries.
Today, fully registered bonds are registered as to principal and interest. The registrar tracks owners, and the paying agent sends semiannual interest payments directly to the registered owner.
The Indenture
Bonds are issued under a bond contract called an indenture. It defines interest rate, maturity, collateral, and all features. An independent trustee monitors compliance.
Test Tip: All corporate issues of $50,000,000 or more must have a trust indenture as specified by the Trust Indenture Act of 1939. Municipal and government issues are exempt.
Secured Bonds
Secured bonds have collateral pledged to back the issue. Unsecured bonds have no collateral backing.
Secured bonds are sold at lower interest rates than unsecured bonds because of the extra protection provided by collateral.
| Type | Collateral | Key Features |
|---|---|---|
| Mortgage bonds | Real estate or equipment | Open-end or closed-end indenture |
| Equipment trust certificates | Equipment (planes, trucks, trains) | Serial form; non-callable; highly rated |
| Collateral trust certificates | Portfolio of securities | Parent uses subsidiary securities |
Unsecured Debt Instruments
| Type | Description | Key Features |
|---|---|---|
| Commercial paper | Short-term (14-365 days) | Sold at discount; $100K minimum; rarely exceeds 270 days |
| Debentures | Intermediate/long-term unsecured | Higher credit risk; backed only by promise to pay |
| Subordinated debentures | Junior status in liquidation | Paid after other creditors; may have conversion feature |
| Income bonds | Issued in reorganization | Pays only if issuer has sufficient earnings |
Accrued Interest
| Bond Type | Settlement | Day Count |
|---|---|---|
| Corporate bonds | T+1 | 30/360 |
| Municipal bonds | T+1 | 30/360 |
| Treasury bonds | T+1 | actual/actual |
Convertible Bonds
Convertible bonds can be converted into common stock at a set conversion price.
Example: $1,000 ÷ $50 = 20 shares
Example: 20 × $40 = $800
Example: $900 ÷ 20 = $45
- Bond above parity: No reason to convert (stock worth less)
- Bond below parity: Profitable to convert (arbitrage opportunity)
- Forced conversion: When bondholders convert rather than accept a call
Priorities in Liquidation
| Priority | Creditor Type |
|---|---|
| 1st | Secured creditors (mortgage bonds, equipment trust certificates) |
| 2nd | Unpaid admin claims, wages, taxes, trade creditors |
| 3rd | Unsecured creditors (debenture bondholders) |
| 4th | Subordinated creditors |
| 5th | Preferred stockholders |
| 6th | Common stockholders (residual interest) |
Section 2: U.S. Government and Agency Debt
In 2011, S&P downgraded U.S. government debt from AAA to AA+ for the first time in history. The market reaction? Investors bought more Treasuries, not fewer. When the world panics, it still runs to U.S. government debt—the ultimate safe haven.
Treasury Securities
| Type | Maturity | Interest | Quotes |
|---|---|---|---|
| T-Bills | 1 year or less | None (discount) | Yield basis |
| T-Notes | 2-10 years | Semiannual | 32nds |
| T-Bonds | 10-30 years | Semiannual | 32nds |
STRIPS
STRIPS are Treasury bonds stripped of interest payments, creating zero-coupon obligations. They eliminate reinvestment risk because there are no interest payments to reinvest.
TIPS
TIPS (Treasury Inflation-Protected Securities) have principal that adjusts with the CPI, protecting against purchasing power risk.
- Fixed interest rate paid on adjusted principal
- Principal increases with inflation, decreases with deflation
- Lower yield than regular Treasuries (trade-off for inflation protection)
- Only available for long-term issues
Government Agency Securities
Government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac are not directly backed by the U.S. Treasury but are considered low-risk.
| Agency | Type | Function |
|---|---|---|
| Ginnie Mae (GNMA) | Government agency | Guarantees MBSs; highest credit rating |
| Fannie Mae (FNMA) | GSE | Issues MBSs and CMOs |
| Freddie Mac (FHLMC) | GSE | Issues MBSs and CMOs |
| Sallie Mae (SLMA) | Government agency | Buys student loans (not mortgages) |
Mortgage-Backed Securities (MBSs)
- $25,000 minimum denominations
- Mortgages pooled and divided into pass-through certificates
- Monthly payments of principal and interest passed to holders
- Self-liquidating as mortgages are paid off
- Subject to prepayment risk
Test Tip: Prepayment risk increases when interest rates fall—homeowners are more likely to refinance in low-rate environments.
Collateralized Mortgage Obligations (CMOs)
CMOs are structured in tranches to divide risk among investors. Different tranches have different risk/yield profiles.
| Tranche Type | Description |
|---|---|
| Sequential pay | Most basic; payments applied to one tranche at a time |
| PAC (Planned Amortization Class) | High cash flow stability |
| Principal-only (PO) | Receives only principal payments; very sensitive to rates |
| Interest-only (IO) | Receives only interest payments |
| Z-tranche | Last to receive payments; highest yields |
| Concept | Key Details |
|---|---|
| T-Bills | Short-term; sold at discount; quoted on yield |
| STRIPS | Zero-coupon; eliminates reinvestment risk |
| TIPS | Principal adjusts with CPI; inflation protection |
| MBSs | Pass-through; prepayment risk |
| CMOs | Tranches with varying risk/yield |
Chapter 4 Key Terms Glossary
| Term | Definition |
|---|---|
| Indenture | Bond contract defining all terms and covenants |
| Trustee | Independent party monitoring compliance |
| Secured bond | Bond backed by collateral |
| Mortgage bond | Secured by real estate |
| Equipment trust cert | Secured by equipment; serial form |
| Debenture | Unsecured bond |
| Subordinated | Junior status in bankruptcy |
| Commercial paper | Short-term unsecured; discount |
| Convertible bond | Can convert to common stock |
| Conversion ratio | Par value ÷ conversion price |
| Parity | Bond and stock have equal value |
| T-Bill | Short-term Treasury; discount |
| STRIPS | Zero-coupon Treasury |
| TIPS | Inflation-adjusted principal |
| GSE | Government-sponsored enterprise |
| MBS | Mortgage-backed security |
| CMO | Structured mortgage product |
| Tranche | Section of CMO with specific characteristics |
| Prepayment risk | Mortgages paid early, ending payments |
Chapter 4 covers corporate and government debt. Understanding secured vs. unsecured, the bankruptcy hierarchy, and Treasury/agency securities is essential before Chapter 5: Municipal Debt and Money Market Instruments.