The higher a bond's rating, the less you're supposed to worry about a corporate bankruptcy and vice versa. With the collapse of Enron in 2001, the ratings assigned by agencies came under increased scrutiny. Moody's Investors Service responded to the critical nature of the government scrutiny by sending out a request for information about off-balance-sheet financial arrangements to about 4,200 companies in January 2002. The last time Moody's Investors Service took this action was in 1994, when Orange County, California, filed for bankruptcy.

With a dearth of AAA-rated companies, credit protections have become increasingly important. Secured bonds offer such protections because they have a first claim on specific assets if the corporation is unable to pay. Examples of secured bonds are mortgage bonds, collateral trust bonds, and equipment trust certificates. If you see one of these names in the title of a bond, you know that you have a secured bond. For example, a description might read: "Duke Power, First Mortgage Bonds." This means that the issuer, utility company Duke Power, issued a bond that is secured by a first mortgage on certain of its property. Collateral trust bonds are secured by securities of other companies (usually subsidiaries) owned by the company issuing the bonds. Equipment trust certificates are liens against the rolling stock of railroads or the airplanes owned by an airline company.

Guarantees are also a form of credit protection. Although usually featured on munis, they are sometimes on corporate bonds as well. The guarantees often appear as letters of credit (LOC), which are credit guarantees issued by banks. LOCs provide funds to pay off the corporate bond issue should the corporation default. Another form of a guarantee is when a parent company guarantees the bonds of one of its subsidiaries. Some corporate bonds are insured by the companies that also insure municipal bonds.

Unsecured bonds are known as debentures and are protected only by the full faith and credit of the company. Debentures can receive high bond ratings if the issuing company is financially strong. Bonds with a lesser claim on assets are called "subordinated debentures."

To protect their creditability and to inform investors, rating agencies have developed "watch lists" that indicate when a company's rating might be either raised or lowered. Moody's Investors Service provides its list on its Web site, www.moodys.com. You can enter the name of the bond, or identify it by CUSIP. The Securities and Exchange Commission has the most current information from company filings on its Web site, www.sec.gov/edgar/quickedgar.htm.

Although the overwhelming majority of corporate bonds feature a fixed interest rate, some are offered with variable rates. Long featured in European bonds, variable rates have been attached to U.S. securities only since the 1970s. The rates are tied to some other measure, usually a Treasury bond rate or the London inter-bank offered rate (Libor) and are adjusted at specified intervals. They're called floating-rate notes (FRNs). As with other debt instruments, corporate bonds may be sold as zero-coupon bonds, which means they pay no interest until maturity.

The taxation of corporate bonds is very complicated, and you should consult your tax adviser on the specifics. However, some general points apply if the bonds are not held in a tax-sheltered retirement account:

Corporate bonds provide a predictable stream of income. Interest is usually paid semiannually, although some bonds, if they're notes, pay interest quarterly or monthly. Corporates yield more than Treasury and agency bonds and usually more than other taxable fixed-income investments. They're suitable investments for tax-sheltered retirement accounts and for those in low tax brackets.

The corporate bond is no stranger to event risk. They may be subjected to leveraged buyouts (LBOs) or takeovers. In an LBO, the employer or a purchaser takes the company private, often creating a windfall for the stockholders. However, an LBO may result in great uncertainty for the bondholders because their bonds may be downgraded. LBOs have turned investment-grade bonds to junk overnight, in the process smearing the bonds of similar companies identified as potential acquisition candidates. In 1988, for example, when RJR Nabisco was taken over, prices of many large corporate bonds plummeted across the board as traders reacted to the realization that even large companies were not safe from such hostile actions.^[100]

The credit quality of bonds is often downgraded when corporations try to boost their stock prices. In 2000, for example, scores of companies raised the reported per share earnings by the simple expedient action of buying back their shares even though their earnings did not increase. After all, when you have four shares outstanding and you earn $1.00, your per-share earnings are $0.25. This earning report is doubled to $0.50 when you buy back two shares and, thus, have only two shares outstanding. While the companies were beefing up their per-share earnings, however, they were acquiring boatloads of debt to buy back their shares. Stock buybacks are now a familiar part of the debt landscape. This heavy debt led Moody's Investors Service to downgrade three times as many bonds as it upgraded in that year, a ratio not seen since the recession of the early 1990s.^[101] To discover whether the bonds you own were issued by a company buying back its stock, call your broker and ask if the bonds are on the stock buyback list. Then evaluate your risk. On a cautionary note, never equate a company's rising stock price with good financial health or a willingness to support its out- standing debt.

Floating-rate notes have their own specialized risks. Although the coupon payments adjust to the changes in the marketplace interest rates, they do not adjust to changes in the credit quality of the issuer. Thus, the interest rate being paid is based on the credit quality of the issuer when the floating rate was established.

Although generally issued with a minimum face value of $1,000, corporate bonds are frequently sold in lots of $5,000. Prices for frequently traded issues are currently reported on the Web site www.investinginbonds.com after a lag; however, the market is moving toward greater price transparency.

Although companies generally have only one class of common stock, they usually have many distinct bond issues because some have a better claim on the company's assets in the event of a default than others. Bonds that trade often are easy to evaluate, whereas bonds that seldom trade are more difficult to price.

Basic features. Corporate bonds come with one of three alternative features. You can pick the feature that suits you best.

Sinking funds. These funds are a frequent provision of some types of corporate bonds. They are frequently found in the indentures of industrial bonds and public utilities but not in bonds issued by telecommunications and finance companies.^[102] Although sinking funds might redeem your bonds at an unwanted time, they provide for the orderly repayment of debt. With zero-coupon bonds, however, no debt is repaid at all until the bonds come due. In that case, you place your faith in the issuer's ability to pay all the debt at once.

Make-whole calls. These calls were introduced in 1995, but they are now frequently found in addition to fixed calls. A make-whole call allows the issuer to call a bond whenever it wants at par plus a premium, usually expressed as X basis points over the equivalent Treasury bond. High interest rates, poor ratings, and long maturities produce more "room" for an issuer's borrowing costs to decline if the following happens: interest rates decline, company ratings improve, and the maturity of the bonds shorten. But is this call attractive to the bond buyer? You should still require a price premium for the uncertainty that the bond might be called early and that the price of the bond may not appreciate much over par due to the call possibility. Advantageous circumstances for you would include falling interest rates and rising Treasury bond prices. You would have a higher call price than if there were a fixed call, although you would still have to reinvest at lower rates. It is very expensive for an issuer to exercise this call so it is not exercised frequently.

Puts. Puts are a relatively recent feature in corporate retail notes. They are the opposite of calls in that they allow buyers to redeem their bonds before maturity at face value and without penalty. One variant is the death put. If the bondholder dies, his or her estate can redeem the bond at face value. By its very nature, the death put increases the attractiveness of long-term bonds, especially those selling at a discount to their face value. However, the increase in value may be offset by the taxes due on the gain.

Unadorned puts are often used as an added inducement when an issuer is on credit watch. Another provision is the "step-up," which increases the size of the coupon by a fraction of a percentage point for a stated reason, like a rating agency downgrade. AT&T used both these inducements, plus a juicy yield, to attract buyers for its November 2001 issue.^[103]

Unlike corporate bond offerings that are issued all at once, MTNs are available continuously so you can purchase them at a time that's convenient for you. In addition, coupon rates can be quite attractive for maturities that are beneficial to the issuer.

Because of their flexibility, MTNs are issued both privately and publicly, which allows corporations to conceal some of their debt. MTN offerings are often issued simultaneously with derivatives to hedge company risks. They are then called "structured notes." They may appear to be regular bonds, but they may have exotic derivatives embedded in them. These notes can cause an investor to lose invested principal because the risks are not obvious.

Investors in MTN offerings must have deep pockets because these offerings are usually in the range of $1 million to $25 million. Many brokers step in and buy them for trading purposes. They sometimes slice the MTNs into bonds with much smaller face values, generally in the $1,000 to $5,000 range. These bonds are then sold in packages, with an investor's needs determining the package's total size.

Medium-term notes are issued intermittently when the time is most propitious. Institutional buyers of corporate notes purchase them in blocks of $1 million or more. The small investor will usually not have access to this market except as we've noted.

Simplicity is the hallmark of corporate retail notes. You do not have to understand bond basics to purchase one. Because they're always issued at par, you do not have to understand the differences between premium, discount, and par bonds. Nor do you have to understand accrued interest. Large, highly rated corporations usually issue them. They are convenient, come in a variety of maturities and payment options, and are sold in small lots.

You do not have to decide quickly if you want to purchase them because the offering remains stable for five business days despite market fluctuations. And, there's always next week because new issue corporate retail notes are frequently available and always sell at the same price at every selling broker.

You can lose money on the sale of corporate retail notes. Their price and yield bounce around just like that of any fixed-income investment. They also may have lower yields than institutional corporate notes due to features geared to attract the retail market. This is a buy-and-hold investment because the spreads may be quite wide on the sale although they are negotiable, as with any other bond.

Always ask if the bonds have a senior lien or a subordinated lien on assets before you buy. In the event of a failure to pay in a timely fashion, holders of senior lien bonds can demand accelerated repayment, whereas holders of subordinated lien bonds must wait until an actual bankruptcy filing for assets to be allocated to creditors.

Corporate retail notes provide liquidity for the company when the commercial markets may be closed to them. For company survival, liquidity is always good, although it may not be good for you if they are piling on the debt.

Corporate retail notes are priced at or near par, which is usually $1,000. That is also the minimum purchase amount. They have no accrued interest when first issued. Corporate retail notes do not trade well in the used bond market so make sure you can hold them to maturity before you buy. Diversify among industries because if there is a change in the outlook for an industry or a change in the way the rating agencies look at the ratings, you may have many bonds downgraded at one time.

For information on corporate retail notes look at Direct Access Notes (DANs) through LaSalle ABN AMRO Financial Services at www.directnotes.com and Internotes from Incapital LLC at www.internotes.com. There have been new entrants into the field, with Merrill Lynch issuing CoreNotes, as well as many others. You can get a prospectus from any participating broker/dealer listed on either Web site, or you can visit the Web site of the individual issuers.^[105]

With the introduction of online information, it is easy to check out corporate retail notes offerings each week. The offering sites can e-mail you information on new offerings as they're formulated.

If you purchase monthly pay bonds, they have a slightly higher yield than equivalent semiannual bonds because you receive cash sooner. Not all issuers of these notes will necessarily be identified by a brand name when the notes are sold so inquire about whether you're purchasing a bond, an MTN, a direct access note, or an internote. Most corporate retail notes contain a survivor's option, or death put, permitting the estate of the beneficial owner the right to put (that is, sell) the note back to the issuer at face value, as described in chapter 19.

A high-yield bond is simply one that currently yields more than other available bonds. It does so for any number of reasons, including (1) it's perceived as riskier than other bonds and so must offer a higher return to attract investors; (2) it has an early call date and must offer a higher return to compensate investors for the short amount of time the bond will be held.

Junk bonds are the debris of failing or distressed companies. In 2007, an astounding 71 percent of U.S. industrial corporations tracked by Standard & Poor's fell into this category.^[106] Often paying no interest income because their coupon payments have been abandoned, the bonds are frequently the playthings of speculators. Those who buy these bonds are betting that they will eventually be sold for more than their current market price. Thus, unlike all other bonds, junk bonds are bought more for their capital appreciation potential than for their interest payouts. "Thar's gold in that thar junk!" as the saying goes. However, in 2005, James Grant, editor of Grant's Interest Rate Observer, had a different perspective. "Never before have junk-bond investors been paid so little for risking so much," said Grant.^[107]

The term junk also covers the bonds of rising stars, new start-up companies turning to the bond markets for additional capital. Although the majority of these start-ups have no (or only the most speculative) risk rating, some are promising enough to be in the double-B category and have what the investment community considers interesting possibilities. These bonds can be called junk or, as some prefer, "businessman's risk" bonds.

Finally, some corporate managements deliberately create junk bonds as a protection against hostile takeovers. They make themselves unattractive by saddling themselves with debt from bond offerings and using the resulting funds to pay out high dividends to stockholders, thus, depleting company assets. Suddenly, highly rated bonds become junk bonds, much to the dismay of the bondholders. Who wants to buy a debt-ridden company? The answer is no one if the acquiring company cannot ascertain the depth of the problem. AIG, the world's largest insurer, was ready to sign on for an $833 million foreign investment in Hyundai Group, but Korean regulators refused to provide protection in the event hidden debt bombs exploded.^[108] The deal fell apart.

Junk bonds have had a long, if not always honorable, history in American financial markets. The term first appeared sometime in the 1920s and was used to describe bonds that few would touch because they were below investment grade. Such bonds were also known as fallen angels, a term reflecting the fact that the bonds had once been respectable, investment-grade instruments and then had lost that designation when the issuing companies encountered extreme financial difficulties. Both analysts and investors avoided junk bonds not only because of the likelihood of their defaulting but also because the investment policies of many financial institutions excluded the bonds from their approved lists.

Since the 1980s, however, the application of the term junk bond has broadened. It now applies to bonds issued by established companies undergoing restructurings or LBOs. An LBO is the purchase of a controlling interest in a company through the use of borrowed money. Sometimes, a company will buy itself, changing from a publicly owned to a privately owned entity. When that happens, the once publicly traded bonds are no longer traded and become illiquid; holders then have to wait until the bonds mature to obtain the principal. When Seagate Technology Inc., the world's biggest manufacturer of computer disk drives, announced it would go private in 2001, for example, the trading price of its bonds fell by half.

In the 1980s, two developments had a significant effect on this market. First, the concept of modern portfolio theory became widely embedded in financial planning. In very broad terms, this approach holds that diversification smoothes out risks. In practical terms, it made holding junk bonds more attractive because it meant that the portfolio could capture the high yield of the bonds while reducing the risk of holding them through diversification.

Second, there was Michael Milken. He was, as the well-known quote explains, in the right place at the right time: junk bonds were acceptable portfolio components, and many companies were ripe for hostile takeovers and dismemberment. From his bastion at Drexel Burnham Lambert, Milken saw to it that high-yielding bond issues became the hottest items in town. They financed merger and acquisition activities that were used to take over companies and milk them dry or, as others preferred to describe it, to unlock their unrecognized values.

At the time, Milken was at his high-flying prime. Junk bonds were considered good investments not only for their money-making potential but also because their default rate was quite low. They were so good, in fact, that there was a narrowing in the difference between their yields and that of Treasuries. With the scandal surrounding the collapse of Drexel Burnham Lambert and the onset of the recession in 1990 to 1991, investors fled from junk bonds, selling them for whatever price they could get. The spread between junk bonds and Treasuries, which had once been about 200 basis points, ballooned to 1,200 basis points in November 1990.

Modern portfolio theory, however, remained unaffected. Throughout the 1990s, increasing amounts of high-yield bonds were bought for mutual funds. The attractiveness of their yields was such that even staid investment institutions, such as Vanguard and TIAA-CREF, introduced funds consisting solely of these bonds. Not all such funds are equal because many carry a high-yield name but have numerous investment-grade bonds to cushion the possibility of default.

Junk bonds attract a unique clientele and require analysis that differs from that used for investment-grade bonds. As well-known investment-grade bonds began to slide (including those of Dole Food Company; Hasbro; and AMR, the corporate parent of American Airlines) and with the default rate calculated by Fitch Ratings at 12.9 percent in 2001, up from 5.1 percent in 2000, ten analysts who formerly focused only on either high-grade or high-yield bonds began to cover both types. In 2001, Moody's Investors Service downgraded the ratings of forty-nine such companies as the country slid into a recession.^[109] With telecom companies, investors were lucky to get the quoted price of 14 percent to 20 percent of face value.^[110] By 2006, many telecoms had defaulted. The default rate in 2006 was only 1.3 percent, but that is attributed to low interest rates.^[111]

Bondholders who hear bad news and do not sell their holdings may inadvertently find themselves owners of high-yield paper. When the American automotive industry was unable to effectively compete in the world markets, holders of General Motors, Ford Motor Company, and Chrysler Corporation saw the ratings on their bonds sink below investment grade. The owners of telecoms suffered a similar fate. If you're concerned about a company, suspecting it may be the next Enron or WorldCom, and the media is not proclaiming its demise, ask your broker to call the credit-derivatives desk to ask about the activity for credit-default swaps for the company about which you're concerned. These swaps are basic insurance for big guys if they fear a default or price devaluation, and the activity trend might give you some information.

For knowledgeable players, junk bonds can be very lucrative. In addition to their high yields, they also offer the potential for substantial capital appreciation if you happen to purchase a "rising star" instead of a "falling angel." Under the banner of diversification, investors purchase foreign stock and now high-yield foreign bonds. They are usually sold under the headings of emerging markets, global bonds, or foreign bonds and are usually purchased through mutual funds.

Junk bonds carry the same risks as all other bonds, and then some. Interest rates may rise, depressing the prices at which the bonds are sold. Downturns in the economy affect all businesses, but the weakest companies suffer the most. Liquidity dries up just when you really need it.

The special risk for junk bonds is the heightened possibility of default and further rating downgrades. Credit watch or actual downgrades mean that the value of your bonds declines and their salability diminishes. Default may lead to your losing every dime of your investment. More frequently, you will have some recovery of assets that are paid in cash and securities. A Standard & Poor's study sampling 120 B-rated companies that tapped the debt market in 1996 found that by 2006, 6 percent had paid off their debt, a third defaulted, and a third were acquired.^[112] The overall recovery rate on defaulted corporate bonds "remained well above their 36 percent historical average for 2005,"^[113] although the huge spike in defaults in 2001 and 2002 may have weeded out many of the more vulnerable companies. If you were to hold only a few junk bonds—something few professionals would recommend—what would you expect your experience to be?

Credit issues mainly affect the yield on junk bonds. The price of junk bonds generally does not respond to the movement of interest rates in the same way as better credits do. Treasury yields might change, but yields on junk bonds may not move or will move only fractionally. Traders value junk bonds principally on price discovery: as the prospects of the company improve and the risk of default is reduced, the value of its bonds will increase.

The thin market for these bonds makes them expensive to trade. Junk bonds are difficult to price unless they're actively traded. Their prices are set based on a total return approach, taking into account likely interest payments and return on capital invested. If your bonds are investment grade, and you fear they may be downgraded to junk, it might be advisable to sell before that happens. Trust companies and mutual funds mandated to hold high-grade bonds must sell bonds once they no longer have an investment-grade rating, thus, driving the price of the bonds down.

Some investors make a lot of money trading junk bonds. Generally, these individuals are retired and have time to closely follow bankruptcy proceedings. They make a bet on the reorganization of the company. A lot of bonds trade at the bottom of a bankruptcy when many holders want to get out and are willing to sell at $0.10 to $0.15 on the dollar. If the bet pays off, the return could be $0.40 to $0.50 on the dollar. This type of trading, however, is not for the faint of heart.

Defaulted bonds generally trade flat, that is, without accrued interest. If the bond is heading for default, you might be able to negotiate a sale with a due bill. A due bill is attached if a seller sold securities with interest due that the trustee identifies as belonging to the seller rather than the buyer. If a due bill is attached, the buyer's broker can claim the interest. You get a proportionate share of the next interest payment, if there is one, if you have a due-bill designation. If the buyer's purpose is to become a player in the restructuring by amassing a large block of bonds, he won't care about the interest.

Bond covenants, the written statement regarding the rights of bondholders, are not everyday reading. To give buyers of low-grade debt some hints about what kind of protections might be built into the covenant, in 2006 Moody's Investors Service began analyzing these securities and assigning ratings to them before they're sold. The ratings range from CQ-1, the strongest, to CQ-3, the weakest. One covenant the analysts particularly like is a change-of-control provision, which allows the buyer to give back the bonds at par if the borrower is acquired.^[114]

If you want to purchase junk bonds, consider purchasing them through a mutual fund. Don't forget, however, that junk bonds are especially risky when the economy is heading into a recession.

Ah, convertibles! Back in our dating days, we loved riding along with the top down and the wind blowing through our hair while we debated whether that big black cloud up ahead really meant rain. If you like that kind of racy feeling, then convertibles are for you. They start off as simple, interest-paying bonds that yield less than the market rate, but they may wind up as dividend-paying stocks.

The fun part comes when you get to convert bonds into equity for a fixed number of common stock shares. For example, your $1,000 face value convertible bond might become ten shares of common stock. Alternatively, your convertible bond might specify a conversion price rather than a number of shares. If the price is $100, then the security can be exchanged for ten shares. The term parity price is used to describe the price at which the shares are convertible. In this example, the parity price is $100. There may be a step-up feature that increases the price of conversion after a specified amount of time.

The majority of convertible issuers are below investment grade. Convertibles represent one of the few remaining funding sources available to companies saddled with large debt loads or with very volatile earnings. Management is reluctant to raise new funds by issuing stock because this would dilute and, thus, lower per-share value. By issuing convertibles, a company can have its cake and eat it, too. Often, a convertible bond carries a stipulation that it can be called if the stock appreciates significantly, a process called forced conversion. This provision gives the company leeway to issue either new convertible bonds or new equity shares based on the higher stock price.

Convertibles offer a combination of good interest income and the potential return of a stock. They feature interest payments, which provide a stream of income, and a maturity date when the principal will be returned. In the event of bankruptcy, convertible bonds have senior status over preferred and common stock. If the stock drops, the bonds will theoretically cushion the fall for the convertible holder, while allowing an upside participation if the stock soars.

If a company is increasingly looking like a candidate for bankruptcy, you will find its bonds will not hold their value. And, in the event of bankruptcy or a sinking share price, you will have given up a substantial yield for the benefit of an unattractive conversion feature.

If a company is doing well and the indenture provides that the bonds are callable, you can be sure that a call will happen if the stock price begins to recover. Depending on the price you paid for the bonds, you may suffer a loss and miss an opportunity for a big upside as well.

If you purchase an individual convertible bond and decide: "Now is the time to get out," you might have difficulty finding a buyer. This market is primarily institutional, populated by fund managers and insurance companies. You probably do not have a block of bonds that is attractively sized for them. Who is going to buy ten apples when they're looking for a truckload?

Although the face value for corporate convertibles is generally $1,000, the price you pay for such a bond is based on valuation factors that are considered complex even by sophisticated investors. The purchase price is affected not only by call and put options but also by stock splits and dividend payouts that reduce the value of the stock. There may or may not be antidilution provisions in the bond indenture.

Convertibles behave more like a bond if the bond price is above par, which happens if the bond has a high coupon rate or is a zero-coupon bond selling at a premium to its current value. The bonds may be putable (that is, salable back to the issuer), which is good for you, or callable, which is not because it takes away your options. If you want to purchase convertible securities, you may want to consider buying them through a mutual fund, whose management has done all the work in assessing what is and what is not a good valuation.

Some convertibles have features that permit the issuer to decide when to raise the roof by allowing the company to dictate the timing of the bond conversion to stock. Although rating agencies like a debt conversion based on what is best for the company, it's better for the bondholder to be able to decide when and if to convert.

A conversion price is frequently 20 percent to 35 percent above the share price at the time of issue. For that price to be appealing, you must believe that the stock has good upside potential. Investors eagerly purchased technology convertibles in the 1990s in anticipation of rapid stock appreciation. The "tech wreck" in 2000 derailed windfalls from bond conversions and left many with neither income nor a full return of principal.