Putnam Spectrum Funds

Understanding the capital structure

A company's capital structure shows the types of financing it uses to fund its operations and growth, and there can be attractive opportunities for investors anywhere within it. The capital structure is represented as an inverted triangle because, in most leveraged companies, bank loans tend to compose the largest slice of the corporate capital structure, in terms of value, followed by bonds and equities. This reflects the relatively high debt burdens of leveraged companies.

Bank loans are at the top of the structure because, in the event of a corporate reorganization, they have the first claims on cash flows. In addition, bank loans are considered secured because they are typically backed by collateral, such as a company's buildings or equipment, or its receivables from customers.

Bonds have second priority after loans. Since most bonds are not secured by collateral, they generally pay higher yields to compensate investors for risk. These bonds are typically part of the high-yield asset class.

At the level of equities, preferred shares generally earn a dividend, but lack voting rights, while common equity shares have voting rights, but might not earn a dividend. In the event of a company reorganization or liquidation, preferred shareholders are positioned ahead of common equity shareholders for distributions. Convertibles are technically bonds or preferred stocks that can be exchanged for specified amounts of common stock at a predetermined price. This feature influences their performance. Warrants are options issued by a company that permit the owner to buy shares of common stock at a specified price. Rights are new shares issued to owners of existing shares in proportion to their current holdings, which raises new capital for the company without diluting the ownership of current shareholders.

Why be a common equity shareholder and rank last in the hierarchy? The reason is that common equity shareholders own what is left after all other levels of the capital structure receive what is due them. For all of the higher levels, the claims are more or less fixed. In short, when the company outperforms, much of the extra benefit can flow to the common equity shareholders.