Disadvantages of preferred stock

The two major disadvantages of preferred stock are the seniority of the holder's claims and its cost.
Seniority of the holders´ claims.
Since holders of preferred stock are given preference over common stock holders with respect to the distribution of earnings and assets, the presence of preferred stock in a sense jeopardizes common shareholder's returns. Adding preferred stock to the firm's capital structure creates additional claims prior to those of common stockholders. If the firm's after-tax earnings are quite variable, its ability to pay at least token dividends to common stockholder may be seriously impaired.
Cost.
The cost of preferred stock financing is generally higher than the cost of debt financing. This is because the payment of dividends to preferred stockholders is not guaranteed, whereas interest on bond is. Since preferred shareholders are willing to accept the added risk of purchasing preferred stock rather than long-term debt, they must be compensated with a higher return. Another factor causing the cost of preferred stock to be significantly greater than that of long-term debt is the fact that interest on long-term debt is tax-deductible, while preferred dividends must be paid from earnings after taxes.

Advantages and Disadvantages of Common Stock

Common stock has a number of disadvantage and disadvantages. Some of the factors to be reckoned with in considering common stock financing are discussed below.
Advantages. The basic advantages of common stock stem from the fact that it is a source of financing that places a minimum of constraints on the firm. Since dividends do not have to be paid on common stock and their nonpayment does not jeopardize the receipt of payment by other security holders, common stock financing is quite attractive. The fact that common stock has no maturity, thereby eliminating future repayment obligation, also enhances the desirability of common stock financing. Another advantage of common stock over other forms of long-term financing is its ability to increase the firm's borrowing power. The more common stock the firm sells, the larger the firm's equity base and therefore the more easily and cheaply long-term debt financing can be obtained.
Disadvantages. The disadvantages of common stock financing include the potential dilution of voting power and earnings. Only when rights are offered and exercised by their recipients can this be avoided. Of course, the dilution of voting power and earning resulting from new issues of common stock may go unnoticed by the small shareholder. Another disadvantage of common stock financing is it high cost. Normally, the most expensive form of long-term financing. This is because dividends are not tax-de-ductile and because common stock is a riskier security than either debt or preferred stock.

How municipal bonds are marketed?

The selling of municipals is usually carried out through a syndicate of banks and securities dealers. These institutions underwrite municipals by purchasing them from the issuing unit of government and reselling the securities in the open market, hopefully at a higher price. Prices paid by the underwriting firms may be determined either by competitive bidding among several syndicates or by negotiation with a single securities dealer or syndicate. Competitive bidding normally is employed in the marketing of general obligation (GO) bonds, while revenue bonds more frequently are placed through negotiation.
In competitive bidding, syndicates interested in a particular bond issue will estimate its potential reoffer price in the open market and their desired underwriting commission. Each syndicate wants to bid a price high enough to win the bid, but low enough so that the securities can later be sold in the open market at a price sufficient to protect the group's commission. That is,
Bid price+ underwriting commission= market reoffer price
The winning bid carries the lowest net interest cost (NIC) to the issuing unit of government. The NIC is simply the sum of all interest payments that will be owed on the new issues of municipal bonds is a treacherous business. Prices, interest rates, and market demand for municipals all change rapidly, often without warning. In fact, the tax-exempt securities market is one of the most volatile of all financial markets. This is due in part to the dominant role of commercial banks, whose demand for municipals fluctuates with their net earnings and loan demand. Legal interest-rate ceilings, which prohibit some local governments from borrowing when market rates climb above those ceilings, also play a significant role in the volatility of municipal trading. These combined factors render the tax-exempt market highly sensitive to the business cycle, monetary policy, inflation, and a host of other economic and financial factors. The spectre of high interest rates often forces the postponement of hundreds of millions of dollars of new issues, while the onset of lower rates may unleash a flood of new security offerings.
There is trend today away from competitive bidding and toward negotiated sales of new state and local bonds, due partly to the treacherous character of the tax-exempt market. For example, during 1978 an estimated 53 percent of bonds issued in the market for long-term municipals were negotiated, compared with only 15 percent a dozen years before. This trend has aroused some concern among financial analysis because competitive bidding should result in the lowest net interest cost, reducing the burden on local taxpayers. A recent study sponsored by the Municipal Finance Officers Association (MFOA) concluded that taxpayers have borne some added interest burden as a result of the recent emphasis upon negotiated, rather than combative, sale.
This problem is especially severe in certain states. For example, the AFOA-sponsored study found that in Pennsylvania, where competitive bidding is not required by law, about 95 percent of all bonds sold by local governments were handled through negotiation with a single underwriter group. It was estimated that Pennsylvania local governments paid approximately $14 million in excess interest costs on bond sales totaling about $360 million. On the other side of the coin, underwriting firms argue that they provide extra services to borrowing governments during the negotiation process-services not generally available through competitive bidding. These include preparing legal offering statements, scheduling the sale of new securities, helping to secure desirable credit ratings, and contacting potential buyers.

Recent Trends in Original Maturities of Bonds

There is a trend today toward shorter original maturities for corporate bonds due to inflation, rapid changes in technology, and heavy borrowing demands from other sectors of the economy. During the 1950s and 60s corporations usually found a ready market for 20-to 30-year bonds. Such long-term debt contracts were extremely desirable from the borrowing company's standpoint because they locked in relatively low interest costs for many years and made financial planning much simpler. Today, with inflation and other factors frequently sending market interest rates soaring to records levels, bonds and notes with 3- to 15-year maturities are becoming commonplace.
Some financial analysts expect to see a substantial number of corporate bonds issued in the future whose interest rates are indexed to commodity prices (especially silver and gold) or to the price of energy. These commodity-indexed bonds are designed to provide the investor a hedge against inflation and, as result, carry substantially lower coupon rates than conventional bonds. Another recent innovation is the issuance of zero-coupon bonds which carry no fixed rate of return but offer the investor the prospect of significant capital gains. Those bonds still issued with fixed interest rates may carry "openers" which call for periodic adjustments in the principal amount of the loan as interest rates change. In brief, the trend in corporate bonds today is toward shorter maturities and more flexible rate of return for the investor.

Open versus negotiated markets

Another distinction within the financial system which is sometimes useful is that between open markets and negotiated markets. For example, some corporate bonds are sold in the open market to the highest bidder and bought and sold any number of times before they mature. In contrast, in the negotiated market for corporate bonds, securities generally are sold to one or a few buyers under private contract and held maturity.
An individual who goes to his or her local banker to secure a loan for a new car enters the negotiated market for auto loan. However, a broker instructed to buy a few shares of GM stock will attempt to fill the order by contacting a seller in the open market. Most state and local government securities are sold in the open market. But a growing number are sold under a privately negotiated "treaty" with one or a few buyers. In the market for corporate stocks there are over-the-counter (OTC) sales and the major stock exchanges, which represent the open market. Operating at the same time, however, is the negotiated market for stock, in which a corporation may sell its entire equity issue to a large insurance company or pension funds.

Preferred stock

The other major form of stock issued today is preferred stock. Each share of preferred carries a stated annual dividend expressed as a percent of the stock's par value. For example, if preferred shares carry a $100 par value with an 8 percent dividend rate, then each preferred shareholder is entitled to dividends of $8 per year on each share owned, provided the company declares a dividend. Common stockholders would receive whatever dividends remain after the preferred shareholders receive their stated annual dividend.
Preferred stock occupies the middle group between debt and equity securities, including advantages and disadvantages of both forms of raising long-term funds. Preferred stockholders have a prior claim over the firm's assets and earnings relative to the claim of common stockholders. However, bondholders and other creditors of the firm must be paid before either preferred or common stockholders receive anything. Unlike creditors of the firm, preferred stockholders cannot press for bankruptcy proceedings against a company which fails to pay them dividends. Nevertheless, preferred stock is part of a firm's equity capital and strengthens a firm's net worth account allowing is to issue more debt in the future. It also is a more flexible financing arrangement than debt since dividends may be passed if earnings are inadequate or uncertain and there is no fixed maturity date.
Generally, preferred stockholders have no voice or vote in the selection of management unless the corporation "passes" dividends (i.e., fails to pay dividends at the agreed-upon time). A frequent provision in corporate charters gives preferred stockholders the right to elect some members of the board of directors if dividends are passed for a full year. Dividends on proffered stock, like those paid on common stock are not a tax-deductible expense. This makes preferred shares nearly twice as expensive to issue as debt for companies in the top-earning bracket. However, IRS regulations specify that 85 percent of the dividends on preferred stock received by a corporate investor are not taxable. This tax-exemption feature makes preferred stock especially attractive to companies seeking to acquire ownership shares in other firms and sometimes allows preferred stock to be issued at a lower net interest cost than debt securities. In fact, corporations themselves are the principal buyers of preferred stock issues.
Most preferred stock is cumulative, which means that the passing of dividends results in an arrearage which must be paid in full before the common stockholders receive anything. A few preferred shares are participating, allowing the holder to share in the residual earnings normally accruing entirely to the common stockholders. To illustrate how the participating feature might work, assume that an investor holds 8-percents participating preferred stock with a $100 par value. After the issuing company's board of director's votes to pay preferred shareholders their stated annual dividend of $8 per share, the board also declares a $20-a-share common stock dividend. If the formula for dividend participation calls for common and preferred shareholders to share equally in any net earnings, then each preferred shares will earn an additional $12 to bring its total dividend to $20 per share as well. Not all participating formulas are this generous, however, and most preferred issues are nonparticipating since the participation feature is detrimental to the interests of the common stockholders.
Most corporations plan to retire their preferred stock, even though it carries no stated maturity. In fact, the bulk of preferred shares issued today have call provisions. When interest rates decline, the issuing company may exercise the call privilege at the price (which usually includes a premium over par) stated in the formal agreement between the firm and its shareholders. A few preferred issues are convertible into shares of common stock at the investor's option. The company retires all converted proffered shares and may force conversion by simply exercising the stock's call privilege. New preferred issues today are often accompanied by a sinking fund provision whereby funds are gradually accumulated and set aside for eventual retirement of preferred shares. A trustee is appointed (usually a bank trust department) who collects sinking fund payments from the company and periodically calls in preferred shares or occasionally purchases them in the open market. While sinking fund provisions allow the issuing firm to sell preferred stock with lower dividend rates, payments into the fund drain earnings and reduce dividend payments flowing to common stockholders.
From the standpoint of the investor, preferred stock represents an intermediate investment between bonds and common stock. Preferred shares often provide more income than bonds but also carry greater risk. Preferred shares prices fluctuate more widely than bond prices for the same change in interest rates. Compared to common stock, preferred shares generally provide less total income (considering both capital gains and dividend income) but are, in turn, less risky. They appeal to the investor who is looking for a favorable, but moderate rate of return.
Among major corporations preferred stock experienced a resurgence of interest during the 1970s due to high debt financing cost, the greater flexibility of preferred stock financing over bonds, and pressure on many firms (especially public utilities) to rebuild their equity positions. The numbers of issues of preferred stock listed on the New York stock exchange reached a low of 373 in 1965 and then rose to record highs during the 1970s. Many of these new preferred stock issues proved to be extremely popular with investors because of their high dividend yields, which, in several recent periods, have averaged about twice as large as the dividends yield on listed common stock.

Common stock

The most important from of corporate stock is common stock. Like all forms of equity, common stock represents a residual claim against the assets of the issuing firm, entitling the owner to a share in the net earnings of the firm when it is profitable and to a share in the net market value (after all debts are paid) of the company's assets if it is liquidated. By owning common stock the investor is subject to the full risks of ownership, which means that the business may fail or its earnings may fall risks of ownership, which means that the business may fail or its earning may fall to unacceptable levels, however, the risks of equity ownership are limited since the stockholder is liable only for the amount of his or her investment of funds.
If a corporation with out standing shares of common stock is liquidated, the debts of the firm must be paid first from any assets available. The preferred stockholders then receive their contractual share of any remaining funds. The residual, whatever is left, accrues to common stockholders on a pro rate basis. Unlike many debt securities, common stock is generally a registered instrument with the holder's name recorded on the issuing company's books.
The volume of stock that a corporation may issue is limited by the terms of its charter of incorporation. Additional shares beyond those authorized by the company's charter may be issued only by amending the charter with the approval of the current stockholders. Some companies have issued large numbers of corporate shares, reflecting not only their need for large amounts of equity capital, but also a desire to broaden their ownership base across millions of shareholders. For example, American Telephone and Telegraph (AT&T) have more than 700 million shares of common stock listed on the New York stock exchange. International business machines (IBM) lists more than 580 million shares.
The par value of common sock is an arbitrarily assigned value printed on each stock certificate. Par is usually set low relative to the stock's current market value. In fact, today some stock is issued without any par value. Originally, par value supposed to represent the owners´ original investment per share in the firm. The only real significant of par today is that the firm cannot pay any dividends to stockholders which would reduce the company ´s net worth per share below the par value of its stock . In addition, in the event of liquidation or bankruptcy, the common stockholders may be liable under some circumstances to creditors of the firm for the difference between par value and the subscription price of the stock.
Common stockholders are granted a number of rights when they buy a share of equity in a business corporation stock. Stock ownership permits them to elect the company's board of directors which, in turn, chooses the firm's officers responsible for day-to-day management of the company. Most companies grant a preemptive right when stock is purchased (unless specifically denied by the firm's charter ) which gives the individual shareholder the right to purchase any new voting stock, convertible bonds, or preferred stock issued by the firm in order to maintain his pro rate share of ownership. For example, if a stockholder holds 5 percent of all shares outstanding and 500 new shares are issued, this stockholder has the right to subscribe to 25 new shares.
While most common stock grants each shareholder one vote per share, nonvoting common is also issued occasionally. Some companies issue class a common which as voting rights and class B common which has a prior claim on earnings but no voting power. Te major stock exchanges do not encourage publicly held firms to issue classified common stock, but classified shares are used extensively by privately held firms.
A right granted to all common stockholders is the right of access to the minutes of stockholder meetings and to lists of existing shareholders. This gives the stockholders some power to reorganize the company if existing management or the board of directors is performing poorly. Common stockholders may vote on all matters which affect the firm's property as a whole, such as a merger, liquidation, or the issuance of additional equity shares. This vote may be cast in person or by revocable proxy (which is a temporary assignment of voting power and an instruction on how to vote) granted to a trustee.

the informal over-the-counter market

The large maturity of securities bought and sold in the United States, especially debt securities are traded over-the-counter (OTC) and not on organized exchanges. The customer places a buy or sell order with a bank, broker, or dealer which is ten relayed via telephone, by wire, or by computer terminal to the particular dealer or broker with securities to sell or an order to buy. Each broker or dealer seeks the best possible price on behalf of himself or his customer, and the resulting competition to find the "best deal" brings together traders located hundreds or thousands of miles apart. The prices of actively traded securities respond almost instantly to the changing forces of demand and supply so that security prices constantly hover at or near competitive, market-determined levels.
All money market instruments are traded in the over-the-counter markets as are the large majority of government (federal, state, and local) bonds and corporate bonds. While most common stocks are traded on the exchanges, an estimated one quarter to one third of all stocks are traded OTC. The OTC Market is generally preferred by financial institutions, especially commercial banks, bank holding companies, mutual funds, and insurance companies, because in many cases their shares are not actively traded and OTC trading and disclosure rules are less restrictive. The presence of financial institutions tends to give the OTC market a more conservative tone than the exchanges.
Many dealers in the OTC market act as principal instead of brokers as on the organized exchanges. That is, they take "positions of risk" by buying securities outright for their own portfolios as well as for retail customers. Several dealers will handle the same stock so the customer can shop around. All prices are determined by negotiation with dealers acquiring securities at a bid price and selling them at an asked price. The OTC market is regulated by a code of ethics established by National Association of security Dealers, a private organization which encourages ethical behavior among its members. Trading firms or their employees who break NASD‘S regulations may be fined, suspended, or thrown out of the organization.
One of the most important contributions of NASD in recent years has been the development of NASDAQ-the National Association of security Dealers Automated Quotations System. Launched in 1971, NASDAQ displays bid and asked prices for thousands of OTC-traded securities on video screens connected electronically to a central computer system. All NASD-member firms trading in a particular stock report their bid-ask price quotations immediately to NASDAQ. This nation-wide communications network allows dealers, brokers, and their customers to determine instantly the terms currently offered by major securities dealers.

Limitations of the Liquidity preference Theory

Still, liquidity theory has important limitations. It is only a short-run approach to interest-rate determination because it assumes that income levels remain constant. In the longer run, interest rates are affected by changes in the level of income. Indeed, it is impossible to have a stable-equilibrium interest rate without also reaching an equilibrium level of income, savings, and investment. Then, too, liquidity preference considers only the supply and demand for money, whereas business, consumer, and government demands for credit clearly have an impact upon the cost of credit to these borrowers. A more comprehensive view of interest rates is needed which considers the important roles played by all actors in the financial system-businesses, households, and governments.

Securities Dealers Transactions

Trading among securities dealers and between dealers and their customers' amounts to billions of dollars a day. Average daily transactions in the U.S. government securities market were in excess of $13.1 billion in 1979. Indeed, so large is the government securities market that the volume of trading usually exceeds by four or five times the total volume of trading on the major U.S. stock exchange. The majority of traders by far are in treasury bills. It is also clear that government securities dealers trade heavily among themselves, usually trough brokers. Government security brokers do not take investment positions themselves but try to match bids and offers placed with them by dealers and other investors.
Dealerships are a cutthroat business where each dealer firm is out to maximize its returns from trading even if gains must be made at the expense of competing dealers, indeed, market analysts housed within each dealer firm study the daily price quotations of their competitors. If one dealer temporarily under prices some securities (I.e., offers excessively generous yields), other dealers are likely to rush in for a "hit" before the offering firm has a chance to correct its mistake. It is a business with little room for the inexperienced or slow-moving trader. Yet, as we have seen, the government securities dealers are essential to the smooth functioning of the financial markets and to the successful placement of billions of dollars in new U.S. government securities issued each year.

sources of Dealer financing

Where government security dealers do derives most of their funds to purchase and carry securities? Commercial banks are the largest single source of dealer funds, year in and year out. Indeed, half A dozen of the largest dealers are really dealer departments housed in some of the nation‘s largest banks. However, non-financial business corporations are the most rapidly growing source of funds for major securities dealers. Many industrial corporations. Today find the dealer loan market a convenient and safe way to dispose of temporarily idle monies. With wire transfer of funds between banks readily available, a company can lend a dealer millions of dollars in idle cash and recover those funds in a matter of hours if a cash emergency rears its head.

Dealer Positions in Securities

Dealer holdings of U.S. government and other securities are both huge and subject to erratic fluctuations. For example, during 1979, the roughly three dozen U.S. government security dealers held average daily positions of $3.2 billion in U.S. government securities and nearly $1.5 billion in the IOUs of various federal agencies. Three years earlier, in 1976, however, average daily dealer positions in U.S. government securities were more than double the average at almost $7.6 billion.
Why was there such a tremendous difference in the size of dealer portfolios during those years? Interest rates fell in 1976, creating ample opportunities for sizable dealer profits on securities held in long positions as market prices rose. In 1979, however, interest rates increased sharply, sending security prices downward. Fearing substantial losses, the dealers shifted out of long positions, especially in longer-term notes and bonds, and held mostly Treasury bills, whose prices are relatively stable. In fact, the dealers actually went short on 1-to-5-year and under-1-year government securities and held only nominal amounts of maturities exceeding 10 years

The Liquidity Premium View of The Yield Curve

the strong assumption underlying the unbiased expectations theory coupled with the real-world behavior of investors have caused many financial analysts to question the theory‘s veracity. securities dealers and analysts who trade actively in the financial markets frequently argue that other factors decides rate expectations also exert a significant impact on the character of the yield curve.
For example, in recent years most yield curves have sloped upward. Is there a built-in bias toward positively sloped yield curves due to factors other than interest-rate expectations? The liquidity premium view of the yield curve suggests that such a bias exists.
Longer-term securities tend to have more volatile market prices tan short-term securities. Therefore, the investor faces greater risk of capital loss when buying long-term financial instruments. To overcome this risk, it is argued, investors must be paid an extra return in the form of an interest-rate premium to encourage them to purchase long-term securities. This rate premium for the surrender of liquidity on longer-term issues, if it exists, would tend to give yield curves a bias toward an upward slope.
Why then do some yield curves slope downward? In such instances, expectations of declining interest rates plus other factors simply overcome the liquidity premium effect. The liquidity premium view does not preclude the important role of interest-rate expectations in influencing the shape of the yield curve. Even though expectations may be the dominant factor influencing the yield curve, however, other factors such as liquidity play an important role as well.
Moreover, the liquidity argument may help explain why yield curves tend to "flatten out" at the longest maturities. There are obvious differences in liquidity between a 1-year and 10-year bond, but it is not clear that major differences in liquidity exist between a 10-year bond and a 20-year bond, for example. Therefore, the size of the required liquidity premium paid to long-term investors may decrease for securities of the longest maturities

policy Implications of the expectations hypothesis

The expectations hypothesis has important implications for public policy. The theory clearly implies that changes in the relative amounts available of long-term versus short-term securities do not influence the shape of the yield curve unless investor expectations also are affected. For example, suppose the U.S. Treasury decided to refinance $100 billion of its maturing short-term IOUs by issuing $100 billion in long-term bonds. Would this government action affect the shape of the yield curve? Certainly, the supply of long-term bonds would be significant increased, while the supply of short-term securities would be sharply reduced. However, according to the expectations theory, the yield curve itself would be unchanged unless investors altered their expectations about the future course of short-term interest rates.
To cite one more example, the Federal Reserve System buys and sells U.S. government and federal agency securities almost daily in the money and capital markets in order to promote the nation‘s economic goals. Can the Fed influence the shape of the yield curve by buying one maturity of securities and selling another? Once again, the answer is no, unless the Federal Reserve can influence the interest-rate expectations of investors. Why? The reason lies in the underlying assumption of the unbiased expectations hypothesis: investors regard all securities, whatever their maturity, as perfect substitutes. Therefore, the relative amounts of long-term bonds versus short-term securities simply should not matter to investors

Marketable Public Debt

The Marketable Public Debt today is composed of just three types of securities- Treasury bills, notes, and bonds. By law, a U.S. Treasury bills must mature in one year or less. In contrast, U.S. Treasury notes range in original maturity from 1 year to 10 year, while Treasury bonds carry any maturity, though generally they have a maturity at issue of more than 10 years.
Under federal law, Treasury bonds can carry a maximum interest rate of 4¼ percent, unless special exemption from this legal interest- rate ceiling is granted by Congress. Because only limited exemptions have been granted and interest rates have been far higher than 4¼ percent in recent years, the proportion of long-term bonds making up the Treasury‘s marketable debt has declined significantly. In contrast, Treasury bills and notes carry no legal interest-rate ceiling. Moreover, with their greater liquidity and marketability, bills and notes have been especially attractive to investors in recent years. bills and notes represented about 40 percent of all marketable government obligations in 1960; by 1980, however, these securities accounted for more than 85 percent of the marketable public debt.

The secondary market for corporate bonds

The resale (secondary) market for corporate notes and bonds is relatively limited compared to the market for common stock, municipal bonds, and other long-term securities. Trading volume is thin, even for some bonds issued by the largest and best-known companies. Part of the reason is the small number of individuals active as investors in this market. Individuals generally have limited investment time horizons (holding periods) and tend to turn over their portfolios rapidly when attractive alternative investments appear. In the past secondary market trading in corporate bonds was also held back by the buy and holds strategy of major institutional investors, especially insurance companies and pension funds. Many of these firms purchased corporate bonds exclusively for their interest income and were content to purchase the longest-term issues and simply hold them to maturity. Today, however, under the pressure of volatile interest rates and inflation, many institutions buying bonds have shifted into a new aggressive strategy often labeled "total performance." Institutional portfolio managers are more sensitive today to changes in bond prices and look for near-term opportunities to trade bonds and score capital gains. In fact, a number of insurance companies, pension funds, and mutual bond funds operate their own trading desks and keep a constant tab on developments in the corporate debt markets.
Unlike the stock market, there is no one central exchange for bond trading which dominates the market. While corporate bonds are traded on all major securities‘exchanges, including the New York (NYSE) and American (AMEX) exchanges, most secondary market trading in bonds is conducted over the telephone trough brokers and dealers. Bond brokers act as middlemen by arranging trades between dealers in return for a small commission. Dealers, on the other hand, commit themselves to take on large blocks of bonds either from other dealers or from pension funds, insurance companies, and other clients. While bond dealers used to carry large inventories of securities in anticipation of customer orders most major dealer houses today have sharply reduced their inventory positions due to rapid and often unpredictable changes in interest rates. Many dealers now try to close out positions taken in individual bond issues in just a few days, frequently act only as middlemen in trades between major institutional investors without committing their own capital, and often hedge against the risk of large trading losses by using the financial futures markets.

Principal investor in corporate Notes and Bonds

During the 1960s and early 1970s small investor "rediscovered" corporate notes and bonds in their search for higher yields to offset inflation and increased taxes. As the 1970 drew to a close and the 1980s began, however, the interest of small investors in corporate bonds sagged again in the face of soaring inflation and more attractive returns available from money market funds, common stock, real estate, and other assets.
Today, the market foe corporate notes and bonds are dominated by insurance companies and pension funds. The latter prefer buying corporate bonds in the open market, while insurance companies frequently purchase their corporate securities directly from the issuing company in an "off-the market" transaction. The stability of cash flows experienced by pension funds and insurance companies permits them to pursue corporate debt obligations with long maturities and lock in their high market yields. Both federal and state laws, however, require these institutions to be "prudent" in their selection of notes and bonds, which generally means buying investment-grade issues in the top four rating categories established by Moody‘s and standard&Poor‘s Corporation.
Commercial banks are not prominent investors in corporate bonds. Generally, a banker would prefer to deal personally with his business customer and grant a loan specifically tailored to the borrower‘s needs rather than enter the highly impersonal bond market. Increasingly in recent years commercial banks have become direct competitors with the corporate note and bond markets through the granting of term loans. A term loan is any loan granted by commercial bank for business purposes which has a maturity of more than one year. Responding to inflation and the soaring cost of business equipment and facilities, bankers have gradually extended the maturity of term loans with many now falling in the 5- to 10-year maturity range. Rates on such loans generally exceed the interest cost on corporate debt sold in the open market, however, especially when banks insist that the borrowing firm keep funds on deposit equal to a specified percentage of the loan.

Industrial Development Bonds

In recent years state and local governments have become much more active in aiding private corporations to meet their financial needs. One of the most controversial forms of government-aided, long-term business borrowing is the industrial development bond (IDB),developed originally in the southern states during the Great Depression of the 1930s and used today by local governments scattered throughout the nation. These bonds are issued by a local governmental borrowing authority in order to provide buildings, land, and\or equipment to a business firm. Because governmental units can borrow more cheaply than most private corporations the lower debt costs may be passed along to the firm as an added inducement to move to a new location, bringing new jobs to the local economy. The business firm normally guarantees bond interest and principal payments by renting the building, land, and\or equipment at a rental fee high enough to cover their cost.

Mortgage Bonds

Debt securities representing a claim against specific assets (normally plant and equipment) owned by a corporation are known as mortgage bonds. These bonds may be either closed end or open end. Closed-end mortgage bonds do not permit the issuance of any additional debt. Against those assets already pledged under the mortgage. Open-end bonds, on the other hand, do allow additional debt to be issued against pledged assets, and this may dilute the position of the current bondholders. For this reason, open-end mortgage bonds typically carry higher yields than closed-end bonds. Sometimes several different mortgage bonds with varying priorities of claim will be issued against the same assets. For example, the initial issue of bonds against a corporation‘s fixed assets may be designated first mortgage bonds, and later, second mortgage bonds may be issued against those same assets. If the company were liquidated and the pledged assets sold, holders of second mortgage bonds would receive only those funds left over after holders of the first mortgage bonds were paid off.

Debentures

There are many different types of corporate bonds issued today. One of the most popular is the debentures, which is not secured by any specific asset or assets owned by the issuing corporation. Instead, The holder of a debenture is a general creditor of the company and looks to the earning power and reputation of the borrower as the main source of the bond‘s value.