Wednesday, July 8, 2009

What are the different type of bonds?

The last few days I have been writing on bonds. I wrote on what a bond is and what are the differences in yield and risk associated with bonds that are issued by various entities.

There are different types of bonds. You would remember from my first post that a bond

(i) is issued at a price that may or may not be different from the face or par value,
(ii) pays coupons or interests at different times of the year,
(iii) has a maturity date and
(iv) at maturity the issuers will pay you your principal back.

However not all bonds are the same. Some bonds would have one or more of the characteristics change to either the advantage of the issuer or the bond holder. If the advantage is to the issuer the bond will be cheaper,have a higher yield or heavily discounted. If the advantage is to the bond holder the bond will be more expensive to buy, have a lower yield or issued at a premium.

Here are the different types of bonds that i know.

1. Fixed rate bond also called straight bond or plain bond.
This would be the most common type of bonds. This bond will be issued and will mature after a period of time. It will pay coupon or interest twice a year at a given rate that would remain fixed until the bond matures. The principal or the face value will be paid upon maturity along with one last coupon.

2. Zero-coupon or Accrual bond

This type of bonds would pay no coupon or interest. It would be issued at a big discount and at maturity you would get back your principal. If the bond has a par or face value of $ 100 it might be issued at $ 60. And at maturity you would be paid the sum of $ 100.

This is not good for the investor since if the issuer default you would lose everything especially if the bond has a long maturity. So better avoid this one.

This is a type of bond that makes no coupon payments but instead is issued at a considerable discount to par value. For example, let's say a zero-coupon bond with a $1,000 par value and 10 years to maturity is trading at $600; you'd be paying $600 today for a bond that will be worth $1,000 in 10 years.

3. Perpetual bond

A perpetual bond is a bond that has no maturity date. It will continue to make coupon payments from the time it is issued for ever. However there is a trick in it. It is also a callable bond. See below for what a callable bond is. It means that after a period of 5 years or depending on the stipulations of the bond the issuer can recall it at any time and give you back your principal.

However if it is not callable, then it would be similar to stocks with the exception that you will not have voting rights. However you coupon rate will be fixed compared to shareholders who are not certain to receive dividends

This is a nice bond to invest into since you have the possibility to get coupon payments for a long time. However this type of bond is rarely issued and personally I would discourage this type of bonds since it give some uncertainty in your portfolio. It is better to just invest in a long term bond or medium term bond if that is your wish.

4. Inflation-indexed bond
This is a bond that is protected against inflation. It is going to have a coupon rate that is a few percentage point above the official interest rate. This will ensure that you do not lose money in high inflationary times when the rate of inflation will be higher that the coupon rate of normal bond.

5. Convertible bond

A convertible bond is one that will give you the right to convert it into a certain number of shares of the issuing company. You would however remember from above that stocks and bonds each has its own advantages so think well before converting your bonds.

6. Reverse convertible

This bond is the reverse of the convertible bond in that it gives the issuer the right to convert the bond to cash or stocks of a company. As you may have guess this is not good for you since it gives the company more rights than you.

7. Callable bond

A callable bond gives the issuer the right to call the bonds before maturity and pay the bond holder his principal.
This is not advisable for a bond holder, because if you have locked in a high coupon rate, you would not want the company to call it back and then be forced to buy a bond with a lower coupon rate.

8. Puttable bond

A puttable bond gives the bondholder the right to sell the bond back to the issuer before the maturity date. This is advisable if you are buying bonds at a low coupon rate and you are anticipating a rise in bond coupon rate.

* Inverse floaters pay a variable coupon rate that changes in direction opposite to that of short-term interest rates. An inverse floater subtracts the benchmark from a set coupon rate. For example, an inverse floater that uses LIBOR as the underlying benchmark might pay a coupon rate of a certain percentage, say 6%, minus LIBOR.

9. Exchangeable bond

Such a bond is similar to the convertible bond except that it gives the bondholder the rights to convert the bond into stocks of a particular company at a particular time in the future and in certain condition.

10. Floating rate bond

A floating rate bond is one whose coupon rate will vary with a certain index such as the rate on the 6 month treasury bill. So if you think that the 6 month treasury bill rate is going to rise you can buy a floating rate bond and linked it to the index.

11. Inverse floating rate bond

This bond will have a coupon rate that will be as in the floating rate bond above except that the coupon rate will be a number minus the index. For example you might want the coupon rate to be (10 - yield on a treasury bill )%. Hence if you are anticipating the rate on the treasury bill to fall you can buy an inverse floating rate bond linked to it.

One last piece of information. These bond flavors are not without effort. For those that comes at an advantage to the bondholder a fee must be paid with the cost price. For those that come at an advantage to the issuer a discount or an increase yield is needed.

If you have any questions or you think that i have missed one please leave a comment below.

What is a bond?
Stocks have higher return than bonds
Introduction to diversification
What is a bond ladder?
The importance of the bond issuer?

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1 comment:

  1. According to me make a proper analysis of sectors where you want to invest and also see the compatibility and the profitability of that sectors is the perfect way to invest. The professional attitude of investment is like you should invest for long term and don’t follow the crowd.