The Position of Bondholders in Investment Banking - dummies

The Position of Bondholders in Investment Banking

By Matt Krantz, Robert R. Johnson

In investment banking, the capital structure of a firm describes who has supplied the funds to the firm and where those suppliers stand in seniority in terms of being paid back. A company’s capital structure is a breakdown of where the money used by the company has come from, be it stockholders or bondholders.

If a firm gets into financial difficulty and the assets have to be liquidated, bondholders are in line to be paid before any money accrues to stockholders. This is an enormous advantage. How well bondholders are protected is related not only to the value of the assets but also to how much of the capital was supplied by bondholders versus stockholders.

The larger the proportion of equity in the capital structure, the larger the equity cushion (safety net) for bondholders. A company that has 20 percent debt and 80 percent equity has a much greater equity cushion than one that has 80 percent debt and 20 percent equity.

Not all bonds are created equal. Any investor must know exactly where in that proverbial line she stands. How close you are to the front of the line determines the probability that you’ll be repaid.

Some bonds are secured (backed by certain assets of the borrower). In the case of default, the secured bondholder can force the sale of the pledged assets in order to satisfy her claims. These bonds are also referred to as mortgage bonds.

Only after the secured bondholders have been paid are the debenture holders (the bondholders who hold debt that is not backed or secured by specific assets of the company) eligible to be paid. Debenture holders are often referred to as unsecured creditors.

There are even differences in seniority between debenture holders — not all debenture holders have the same place in line for receiving payment if the company runs into trouble because there are senior and junior debenture holders.

Last in the bond line are the junior debenture holders. They’re paid only if all the other more senior bondholders’ possessive claims are satisfied. As with most lines for scarce resources, the further back you stand in the line, the greater the probability that you’ll walk away empty-handed.