Corporate Bonds

These are bonds issued by private companies that are usually based on how financially sound the issuing company is. They are viewed as less secure than both U.S. government issues and most municipal bonds. Corporations issue bonds for many reasons, but the most common one is to raise capital. By issuing bonds, the firm is borrowing money from the bond’s investors. The corporation will then use the money raised to finance different ventures, all the while making interest payments to its bond holders. Then, at maturity, the company will pay the bond holders their original investment.

Some corporate bonds are secured by a claim on all or a portion of the physical property of the issuing company. Examples of these are mortgage bonds and equipment trust certificates. Most corporate bonds, though, aren’t guaranteed in this manner, but rather, they are backed by the full credit of the company with no specific lien on the company’s property. These are called “debentures,” and they generally have first claim on all the company’s assets once all specifically pledged property has been distributed. Subordinated debentures have a claim on assets once all older debt is taken care of. These bond issues may also have what is called a sinking-fund provision. These are designed to eliminate a substantial portion of the outstanding debt prior to the bonds’ maturity.

While many corporate bonds can be called, or redeemed, prior to maturity, many companies now offer securities that give investors protection against their bonds being called for a specific period of time. Many investors are willing to take a lower rate of interest in exchange for some call protection or even noncallable bonds. The option of call protection changes with the condition of the economy. Corporations may also have sinking funds established. These are designed to help the company retire its bonds before the maturity date. The firm will put the money earmarked for the bonds’ repayment into escrow, which it will then use to retire the bonds a few at a time. The investment income derived from a corporate bond is fully taxable for federal income tax purposes. It is also taxable for state income tax purposes in those states that have an income tax. The current interest paid on bonds (coupon rate) is taxed to the investor at ordinary income tax rates. If the bond was purchased at a premium (at a price higher than par value), the investor may choose to amortize the premium over the remaining life of the bond. The investor may then use the amount amortized each year to reduce the bond’s taxable interest or as an itemized deduction, depending on when the bond was bought. Either way, the amortized amount acts as a way to reduce otherwise taxable ordinary income. It also reduces the investor’s tax basis in the bond. If the investor elects not to amortize the premium, it will be added to the basis and will either reduce the capital gain (if the bond is sold for more than the cost) or produce a capital loss (if the bond is sold for less than the cost).