9 Oct 2013

Types of Bonds

Fixed rate bonds have a coupon that remains constant throughout the life of the bond. These bonds are therefore sensitive to the general interest rate environment, and as rates rise the bonds lose value. Floating Rate Notes (FRNs or floaters) pay a coupon that is linked to a money market index, such as LIBOR or EURIBOR, e.g. three-month USD LIBOR + 0.50%. Since the coupon is reset periodically, typically every three months, these bonds are generally insensitive to interest rate movements.

Zero-coupon bonds pay no interim interest. All interest is compounded at the initial internal rate of return and paid out as a lump sum at maturity. As such, they trade at a discount to par value. The main benefit for investors of zero-coupon bonds is the elimination of coupon reinvestment risk. Issuers have the advantage of delaying the interest cash outlay until maturity. However, from a credit risk viewpoint, zero-coupon bonds have more risk as investors have to wait until maturity to receive any income.

High yield bonds are bonds that are rated below investment grade by the credit rating agencies (see section on credit ratings). As these bonds are relatively risky, investors expect to earn a higher yield. These bonds are also called junk bonds or speculative grade securities. High yield bonds tend to be relatively illiquid and are also highly sensitive to the credit quality of the issuer (volatile credit spread that is priced into the bond value expressing the market implied default risk).

Subordinated bonds are those that have a lower priority (than other bonds of the same issuer) in terms of claims over the corporate assets in cases of liquidation. The order in which recovery values are allocated after a default follows what is referred to as the priority of payment, more commonly known as the “waterfall”. Since subordinated bond holders are paid after senior obligations, the risk is higher. Consequently, they have lower credit ratings than obligations higher up the capital structure.

Inflation-linked bonds, in which both the principal amount and the coupon payments are indexed to inflation, offer real rates of return. Therefore, the initial coupon is lower than comparable conventional bonds of the same maturity. However, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation-linked Gilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation-linked bonds issued by the US government. The largest inflation bond market in the Eurozone is in France.

Asset-Backed Securities (ABS) are bonds whose interest and principal payments are backed by cash flow receivables from a pool of underlying assets. Examples of asset-backed securities are Mortgage-Backed Securities (MBSs), Collateralised Mortgage Obligations (CMOs) and Collateralised Debt Obligations (CDOs).

Municipal bonds are securities issued by a state, city, local government, or their agencies primarily in the US. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, subject to local jurisdiction. 

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