When a corporation needs to raise money, it has several options. One is to sell ownership shares in the company in the form of stock; another option is to borrow money. In this instance, the company (issuer) sells bonds, which are a promise to repay the borrowed money with interest. Bonds may also be issued by governments and municipalities to fund public works projects.
Ownership shares in a company are called stocks. The most typical kind of stock is common stock. Common stock gives the stockholder one vote per share in electing the board of directors, who oversee the company’s management. Common stockholders also have a claim on a portion of the profits of a company. The profits may be either reinvested by management or returned to shareholders via dividend payments. Additionally, stocks offer the opportunity for capital growth; as the company grows, a share becomes worth more.
A company might also issue preferred stock. Preferred stock has characteristics of both common stocks and bonds. Like common stock, preferred stock owners have an ownership interest in the company. Like bonds, preferred stocks carry a commitment by the company to pay a fixed amount of interest to shareholders in the form of dividends. However, preferred stocks dividends must be paid before common stock dividends.
A bond offers an investor the opportunity to lend money to the issuer. In return the issuer agrees to pay interest on the loan at a predefined interest rate and payment schedule. The issuer also agrees to repay the principal at a specified maturity date. In the event of a default, bondholders in a corporation have precedence over preferred stockholders who, in turn, have precedence over common stockholders.
Debentures and Secured Bonds
A debenture is an unsecured bond in which the bondholder has no claim on the assets of the bond issuer. Instead, the investor is relying on the reputation and financial position of the issuer. A secured bond is backed by company assets as collateral for the bondholders. If a company is unable to make payments on its secure bonds, the bondholders can force the sale of assets to raise cash to cover the payments due.