Types of Bonds
October 2, 2012 in Bond
Before we talk about different types of bonds, let’s take a look as to what are the possible variables associated with a bond. Logically the variables which can define the types can be as follows:
- Who Issues the bond
- Tenor or maturity period
- Interest Rate
- Interests rate and principal amount payment options
1) Type of Bonds Depending on Who Issues the Bond.
Bonds can be issued either by Government or companies or even city governments or municipalities. Hence according to the issuing entity or borrower the types of the Bonds are as follows:
a) Government Bonds
In US these are also called Treasuries. Government Bonds are the bonds issued by the Governments of the countries.
b) Corporate Bonds
These are the bonds issued by corporations/companies to fulfill the needs of cash for assets and/or operations.
c) Municipal Bonds
Municipal Bonds are the bonds issued by the local municipalities of cities for their needs of cash to run the city and it’s infrastructure.
2) Type of Bonds (Debts) Depending on The Tenor or Maturity Period
Bonds generally have a fixed tenor or maturity period. Different countries may have different nomenclature according to the maturity period but if we talk in terms of US then the basic types of treasuries are as follows:
- Bills: Less than one year maturity period. Strictly speaking these are not bonds because of such a short span of time and hence can simply be called Debt Securities or Treasury Bills.
- Notes: 1 to 10 years. These are also called as Treasury Notes.
- Bonds: 10 or more years.
Now the Bond types according to the maturity time as mentioned above are the standard types of bonds with fixed tenor or maturity period. As mentioned above that some or other type of customization is always possible for any financial instrument to make it more convenient or profitable or efficient for either the borrower or the lender. Considering this there are some other versions as follows:
a) Callable Bonds (Bonds with Call Option):
Bonds with call options or recall options are known as Callable Bonds. Now let’s see what is “Call Option” and why it is required. As we have seen that all bonds normally have a fixed interest rates (we will see the exception later) and a fixed maturity date. Now it may happen that the market interest rates falls drastically because of drop in inflation or rise in deflation. Let’s say that the market interest rates go far lower than the interest rates offered on the bond. Where will that leave the issuer? The issuer of the bond will be paying lot more interest than what was actually planned in terms of the difference of bond interest rate and market interest rates. If the Issuer has the option to recall all the bonds or the part quantity of the same then that higher cost can be saved. Similarly if the interest rates of the currency in concern goes drastically high then it is against the interests of the investors to keep their money stuck with those bonds which are paying much less interest.
The above could be two of the reasons and the third reason is simply the convenience of the flexibility to bring down the maturity period. The Callable bonds give the issuer the right to bring down the maturity period. They can recall the bonds at any date before the maturity date. The Call Price or the redemption price has a premium over the face value of the bond i.e. the call price would be more than the par value or the face value of the bond.
Now there are again two types of Callable bonds or call options:
a1) American Call Option:
Under American call option the issuer can exercise the call option anytime before an specified date.
a2) European Call Option:
Under European call option the issuer can exercise the call option only on specified date(s).
There can again be 2 more types of Callable Bonds and these are as follows:
a3) Refundable Bonds
Let’s say that the benchmark interest rates go down drastically before the maturity period of the bonds. Now if the issuer issues new bonds with lesser coupon value (interest rate) then he will have to pay less money as interest on the same borrowed money. So the issuer issues new bonds with lesser coupon value. The old bonds are called back using the call option and the money for that is paid from the new amounts received from the new bond issue. Rights to this provision are called refundable Bonds.
a4) Non Refundable Bond
Non-Refundable bond will not have the right to pay the money back from any new issue of bonds but the money will be paid to the investors from the normal or general accounts.
Difference in Callable Bonds and Refundable Bonds or Call Option and refundable Bonds:
As we saw above that refundable bonds and non refundable bonds are 2 categories of call options or callable bonds. A callable bond can be refundable bond or non-refundable bond depending on the right of the issuer to pay for the purchase of bond (redemption) for executing the call option.
b) Puttable Bonds (Bonds with Put Option)
Puttable Bonds are opposite to Callable bonds as far as rights to reduce the maturity period is concerned. Puttable Bonds give the investors a right to Put Option i.e. the investors can put the bonds back or redeem those earlier than the maturity date. This makes these bonds a more favorable options for the investors as if the market interest rates are going high then they have an option to redeem their bonds and invest their money with better options of options with higher returns. It may also be possible that an investor needs the cash back because of any reason and hence having this option is always good for an investor.
c) Convertible Bonds:
As we saw earlier that the normal bonds are a fixed income instrument which get matured on a specific date or even earlier with the call or put option and the investors get their invested amount back. Convertible bonds are a customized version and as the name suggests, these bonds are convertible. Convertible bonds do get converted from Bonds to Equity. Or the owner of the bonds become from lender or the money to equity holder in the corporation. The date of conversion and at what price the conversion will take place are pre-decided while the original bonds are issued. Please note that the price of one bond and the price of one stock or share will be different and hence the conversion price has also to be decided. market price of that stock or share may be anything at the time of conversion and hence if the market price is higher than the conversion price then it goes in the favor of the investor. The convertible bonds can be fully convertible i.e. all the bonds are converted into equity or they can be partly convertible i.e. a percentage of the bonds held by the investor are converted into equity and the remaining percentage remain in the form of original bonds with original conditions.
3) Type of Bonds Depending on Interest Rate Options
The original concept of Bonds have a fixed annual interest rates. Some customization in this brings the following types of bonds:
a) Fixed Interest rate Bonds:
No customization and these are the original bonds which give you a fixed annual interest rates
b) Floating Rate Bonds:
As the name suggests that these bond have floating interest rates. If the benchmark interest rate of that country or economic zone changes then the interest rate on the bonds are also changed. Generally there would be some mark up on the bonds interest rates as compared to the normal or bench mark rate to make the investment on the bonds attractive for the investors. Now that markup would may remain same but if the benchmark rate goes down then the interest paid on the bonds also go down and vice versa.
Generally there would be a maximum (cap) and minimum limit (floor) that the interest rate can go beyond that to keep the safety factor.
c) Zero Coupon:
As the name suggests the Zero Coupon Bonds have a Zero Coupon value. These are also known as Deep Discount Bonds. Now the question comes that if the coupon value is zero then why would anyone invest money in those bonds? What about the returns on the investment? Well, the Zero Coupon Bonds are offered at a discount on the face value of the bonds. SO basically when you get the bonds, you get those at much lesser price than their face or par value and when you redeem those at maturity then what you get is the face value. So the difference in the face value of the bond and the discount which you had got at the time of issue is the return on the investment or profit.
d) Treasury Strips:
Treasury Notes are specific to U.S. and is an interesting concept. It may seem complicated concept but we will try to explain it in simple way.
Any bond has two components as far as money is concerned:
1) The principal amount of the bond
2) The interest amount per year till the maturity period.
The above two components together is what we get during the life cycle of the bond and up to the maturity period. Now let’s strip the bond. Take out the interest part or in other words break these two component apart and what we have got? Well, we have got the principle amount with fixed value to be receive on the maturity and we have got the interest part for the duration till the maturity. Now let’s say I want to sell or trade these separately. Let’s take the first part i.e. the Fixed Price of Bonds first. I want to sell it to someone. Will anyone buy that if there is no interest and hence no returns on the investment? Well someone can buy it if I offer it as Zero Coupon bond or bond offered at a discounted price. So one thing is clear that I can trade only the fixed part separately as Zero Coupon Bond.
Now what about the interest part. This is also a fixed amount to be paid over the period of time till maturity. Now I sell these also as a separate security as Zero Coupon Bond. I know the total interest amount and I sell it to someone at a discounted price as Zero Coupon Bond.
Well, the above concept is termed as Treasury Stripes. Stripped bonds where two components are traded separately. Please note that both can have different maturity period as those are already broken apart.
Treasury stripes are not issued directly to the individual investors but can be purchased and held through either financial institutions or government security dealers or brokers.
4) Type of Bonds Depending on Interests rate and Principal Amount Payment Options
a) Amortizing Bonds:
When we take a home loan from the bank basically in a way we become the issuer of a bond and the bank is the investor. The bank earns an interest which is higher than the benchmark rate of interest and that is their earning or returns of the investment. Now when we take a loan, we just pay installments which cover both, the principle amount as well as the interest payable. With our last installment paid we have paid everything including the initial principle amount.
The above is nothing but the concept of Amortizing Bonds. The principle amount along with the interest gets paid in equal 6-monthly installments and after the last amount paid at the maturity date there is no more fixed principle amount to be paid.
b) Sinking Fund Provision Bonds:
First of all let’s see what is “Sinking Fund Provision” and then “What are Sinking Fund Provision Bonds”.
Let’s say you are a corporation of Government you the debt. Every portion of the debt will have some period of time by the end of that you will have to repay it. Now let’s say you have a debt which you have to pay after 10 years. Now for 10 years you will continuously having that liability. Wouldn’t it be better if you can reduce this liability periodically instead of waiting for those 10 years?
If the issuer of the bonds sets up a fund to periodically reduce the debt by buying back the debt (bonds) periodically then such a fund is called “Sinking Fund”. And this concept is known as Sinking Fund Provision.
As we have seen that bonds are nothing but debt or money on loan. The issuer sells bonds to borrow money and he has that debt to be paid as liability till the maturity of the bonds. Now if the issuers keep on reducing that liability periodically instead of waiting till the maturity then the liability will keep on reducing. To summarize, you set up a fund which keeps on reducing your debt in parts over the years instead of waiting for all those years.
Difference in Bonds with Sinking Fund provision and Call Option:
At first glance it would look like the bonds with sinking fund provision are same as callable bonds i.e. bonds with Call Option but there are differences:
1) The issuer can purchase the whole quantity of bonds issues if he has the call option. On the other side the issuer can only purchase certain quantity of bonds periodically with sinking fund provision.
2) Call option’s call price is higher than the face value of the bond but the sinking fund price would equal to either the face value or the current market price whichever is less. So when an investor sells the bonds back to the issuer with call price, he/she gets higher amount than what would come at the maturity. On the other side if the redemption of bonds take place because of sinking fund provision then the price is either the face value price or the current market price if it is lower than the face value.
3) Bonds with sinking fund provision are safer for the investor if something goes wrong with the issuer financially. Because in that case the bonds may become junk bonds or the issuer may even default (failure to pay) and the investor’s investment may be at risk. On the other side the periodic sinking fund provision purchase will make the risk of default lesser even though it cannot avoid it completely.