SIE Ready💵 Debt Securities · Lesson 3 of 7 · 6 min
Who Gets Paid First: Corporate Bonds
🏭 When a company fails, its lenders line up. Where you stand in that line depends on what kind of bond you bought.
💡 Key idea
Liquidation line: secured bondholders, then unsecured debentures, then subordinated debt, then preferred stock, then common stock.
🧠 Why it matters
SECURED bonds are backed by specific collateral: MORTGAGE bonds by real property, EQUIPMENT TRUST certificates by equipment such as railcars or aircraft, COLLATERAL TRUST bonds by securities the issuer owns, held by a trustee. DEBENTURES are unsecured, backed only by the issuer's general credit. SUBORDINATED debentures rank behind other unsecured debt, so they pay more. INCOME (adjustment) bonds pay interest only if earned and are typically issued in reorganizations. CONVERTIBLE bonds can be exchanged for the issuer's stock, so they carry lower coupons. The Trust Indenture Act of 1939 requires most public corporate debt offerings to have a qualified INDENTURE (the contract) and a trustee who acts for bondholders. Ratings of BBB/Baa or higher are INVESTMENT GRADE; lower is high-yield.
📈 In the real world
✈️ Skyline Air issues equipment trust certificates backed by its jets and, a year later, subordinated debentures. When Skyline restructures, the trust certificate holders' trustee can claim the jets. The subordinated holders wait behind every other creditor and recover far less. Their higher coupon was the price of that position.
📌 Takeaways
- Mortgage = real estate, equipment trust = equipment, collateral trust = securities
- Debentures are unsecured; subordinated debentures rank below them
- Investment grade = BBB (S&P/Fitch) or Baa (Moody's) and above
📖 Terms in this lesson
Debenture: An unsecured corporate bond backed only by the issuer's general credit.
Mortgage bond: A corporate bond secured by a lien on the issuer's real property.
Equipment trust certificate: A corporate bond secured by equipment such as aircraft or railcars.
Collateral trust bond: A corporate bond secured by other securities the issuer owns, deposited with a trustee.
Convertible bond: A corporate bond the holder may exchange for a set number of common shares, typically paying a lower coupon in return.
Trust indenture: The contract between a bond issuer and a trustee that sets the issue's terms, required for most public corporate bonds by the Trust Indenture Act of 1939.
Investment grade: A credit rating of BBB (S&P) or Baa (Moody's) or better; lower-rated bonds are called high-yield or junk.
✅ Test yourself
An airline that pledges its aircraft as collateral for a bond issue is most likely issuing:
- Equipment trust certificates
- Collateral trust bonds
- Subordinated debentures
- Income bonds
Answer: A · Equipment trust certificates
Equipment trust certificates are secured by equipment such as aircraft or railcars. Collateral trust bonds are secured by securities, and debentures and income bonds are unsecured.
Under the Trust Indenture Act of 1939, a public corporate bond offering generally needs:
- A qualified indenture and a trustee
- FDIC insurance on principal
- Approval by the Federal Reserve
- A rating of investment grade
Answer: A · A qualified indenture and a trustee
The Act requires a qualified indenture with a trustee acting for bondholders. It does not require any rating, and bonds have no FDIC insurance or Fed approval.
Which bond pays interest only if the issuer has enough earnings?
- A mortgage bond
- An income bond
- A convertible bond
- A debenture
Answer: B · An income bond
Income (adjustment) bonds promise principal but pay interest only when earned, usually after a reorganization. The others owe interest whether or not the company is profitable.
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