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. 

Debt Securities & Bond Characteristics

Debt Securities

A bond is a debt obligation contracted by an issuer/borrower, where the issuer is obliged to make regular payments of both interest and principal. Compared with loans, there is a much more active secondary market and bonds can be sold without requiring the approval of the borrower.

Bond Characteristics

Bonds have the following attributes:

• They generally do not have flexible payment structures. The bond indenture, specifying the rights of bond holders, generally requires approval by a majority (substantial) vote before amendments can be made to the documents
• Their issuance requires some form of public disclosure (the amount of information depends on the market used for issuance)
• Bonds are much easier to sell to investors when they have a credit rating
• The maturity of bonds can be much longer than for bank loans. For example, bank loans are rarely longer than seven years (perhaps beyond ten years for property loans), whereas bonds can be issued with maturities of thirty years and beyond. There are three groups of bond maturities: short term (bills) for maturities up to one year; medium term (notes) for maturities between one and ten years, and long term (bonds) for maturities greater than ten years
• Bonds can be issued paying either fixed or floating interest. Floating rate bonds are called FRNs (Floating Rate Notes). Each year, the amounts of fixed or floating bonds issued vary according to the inclinations of issuers and investors. In the US, most bonds pay a coupon on a semi-annual basis while in Europe, most bonds are annual and pay only one coupon a year. It is also worth noting that each currency market assumes a different day count convention when calculating the accrued interest payable for each coupon (actual/360, actual/365, 30/360 or actual/actual)
• Bonds are less likely to have restrictive covenants. However, in recent years, investors have been able to achieve more protection, particularly the change of control covenant
• Some bonds may contain embedded optionality that grants either the holder or the issuer certain predefined rights. Callable bonds give the issuer the right to repay the principal before the scheduled maturity date on specified call dates at a price typically around the bond’s par value. Such structures are frequently used in the US agency and high yield markets. Puttable bonds offer holders the right to force the issuer to repay the bond before the maturity date on the specified put dates; offering investors extra protection against declining creditworthiness.