Types of Corporate Debt Instruments

There are four main classes of long-term corporate debt instruments: Secured debt, Unsecured debt, Tax-exempt debt, and Convertible debt.

1. Secured debt: Secured debt is backed by specific assets. This backing reduces both the lenders’ risk and the interest rate they require. Mortgage bonds, collateral trust bonds, equipment trust certificates, and conditional sales contracts are the most common types of secured debt.

  • Mortgage Bonds: Mortgage bonds are secured by a lien on specific assets of the issuer. If the issuer defaults-fails to make a required payment of principal or interest-or fails to perform some other provision of the loan contract, lenders can seize the assets that secure the mortgage bonds and sell them to pay off the debt obligation. The extra protection that the mortgage provides lowers the risk. In return, that lowers the required return. But the issuer sacrifices flexibility in selling assets. Mortgaged assets can be sold only with the mortgaged bondholders’ permission or if the borrower provides suitable replacement collateral.
  • Collateral Trust Bonds: Collateral trust bonds are similar to mortgage bonds except that the lien is against securities, such as common shares of one of the issuer’s subsidiaries, rather than against real property such as plant and equipment.
  • Equipment Trust Certificates and Conditional Sales Contracts: Equipment certificates and conditional sales contracts are frequently issued to finance the purchase of capital intensive goods and equipments. Equipment trust certificates are usually issued to finance a leveraged lease. The trust that issues them owns the assets during the term of the lease. Conditional sales contracts are agreements that manufacturers use to finance customer purchases of their goods. They are long-term receivables. These two financing mechanisms are similar: The borrower obtains title to he assets only after it fully repays the debt.

2. Unsecured Debt: Unsecured long-term debt consists of notes and debentures. Notes are unsecured debt with an original maturity of ten years or less. Debentures are unsecured debt with an original maturity greater than ten years. Notes and debentures are issued on the strength of the issuer’s general credit. A financial contract (the bond indenture) specifies their terms; they are not secured by specific property. If the issuer goes bankrupt, note holders and debentures holders are classified as general creditors.

3. Tax-Exempt Corporate Debt: Firms can issue tax-exempt bonds for specified purposes.

4. Convertible Debt: A convertible bond is a bond that can be converted into a predetermined number of shares of the common stock, at the discretion of the bondholder. Although it generally does not pay to convert at the time of the bond issue, conversion becomes a more attractive option as stock prices increases.

Credit: Financial Management-MGU MBA