Corporate bonds, secured and unsecured, the trust indenture, and credit ratings and rating agencies

Corporate debt: promises, collateral, and priority

A corporate bond makes its holder a creditor, not an owner. The issuer promises payments under the bond's terms. Compare three separate questions: what assets support the debt, what the contract requires, and how creditworthy the issuer or issue appears.

A secured bond pledges specific assets. A mortgage bond pledges real property; an equipment trust certificate is backed by equipment; a collateral trust bond pledges securities. A lien gives a claim against the pledged property. An unsecured debenture relies on the issuer's general credit rather than designated collateral. A subordinated debenture ranks behind specified senior debt. Secured claims have priority in their collateral; senior unsecured debt ranks ahead of subordinated debt, and creditors generally rank ahead of preferred and common shareholders. Collateral value and the applicable claims determine actual recovery.

The trust indenture

The indenture is the debt contract between the issuer and a trustee acting for bondholders. It describes interest, maturity, collateral, covenants, call terms, any sinking fund, and default remedies. Covenants may require maintaining insurance or restrict additional borrowing. A sinking fund provides for retiring debt over time. The trustee administers the agreement and acts to protect holders' contractual rights; it does not perform the rating agency's job. The Trust Indenture Act generally applies to covered publicly offered corporate debt, including unsecured debt, but contains exemptions; coverage is not universal.

Credit ratings

A credit rating assesses an obligor's or a particular issue's creditworthiness. Moody's, S&P Global Ratings, and Fitch are familiar rating agencies. A nationally recognized statistical rating organization is a credit rating agency registered with the SEC. Registration is not an endorsement of its ratings.

Moody's uses Aaa, Aa, A, and Baa for investment-grade categories; S&P and Fitch use AAA, AA, A, and BBB. Ba or BB and lower are below investment grade, often called speculative grade or high yield. Ratings address credit risk, not every investment risk, and are opinions rather than repayment guarantees. A highly rated bond can still lose market value when interest rates rise.

An issuer can have differently rated issues because collateral and seniority affect recovery prospects. A downgrade signals weaker assessed credit quality and ordinarily creates upward pressure on required yield and downward pressure on price, other factors unchanged. An upgrade tends toward the reverse. A rating change does not rewrite a fixed coupon or change the indenture's legal payment priority.