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Bond is a financial instrument whereby the issuer of the bond raises (borrows) capital or funds at a certain cost for certain time period and pays back the principal amount on maturity of the bond. Interest paid on bonds is usually referred to as coupon. In simple words, a bond is a loan taken at a certain rate of interest for a definite time period and repaid on maturity.
FEATURES OF A BOND
The entities that borrow money by issuing bonds are called as issuers. In the US, there are mainly 4 major issuers of bonds which include the government, government agencies, municipal bodies, and corporates.
Every bond that is issued has a face value; which is usually the principal amount that is borrowed and returned on maturity. In layman’s term, it is the value of the bond on its maturity.
The rate of interest paid on the bond is called as a coupon.
Every bond is usually rated by credit rating agencies; higher the credit rating lower will be the coupon required to pay by the issuer and vice versa.
COUPON PAYMENT FREQUENCY
The coupon payments on the bond usually have a payment frequency. The coupons are usually paid annually or semi-annually; however, they may be paid quarterly or monthly as well.
The effective return that the investor makes on the bond is called as a return. Assuming a bond was issued for a face value of $ 1000 and a coupon rate of 10% on initiation. The Price at a later date may rise or fall and hence the investor who invests at a rate other than $ 1000 will still receive a coupon payment of $100 (1000 * 10%) but the effective earning shall be different since investment amount is not $1000. That effective return in layman’s term is called as the yield. If the holding period is considered for a year this is referred to as current yield and if it is held to maturity it is referred to as yield to maturity (YTM).
DIFFERENT TYPES OF BONDS
PLAIN VANILLA BONDS :– A plain vanilla bond is a bond without any unusual features; it is one of the simplest forms of bond with a fixed coupon and a defined maturity and is usually issued and redeemed at the face value. It is also known as a straight bond or a bullet bond.
ZERO COUPON BONDS:- A zero coupon bond is a type of bond where there are no coupon payments made. It is not that there is no yield; the zero coupon bonds are issued at a price lower than the face value (say 950$) and then pay the face value on maturity ($1000). The difference will be the yield for the investor. These are also called as discount bonds or deep discount bonds if they are for longer tenor.
DEFERRED COUPON BONDS:- This type of bond is a blend of a coupon-bearing bond and a zero coupon bond. These bonds do not pay any coupon in the initial years and thereafter pay a higher coupon to compensate for no coupon in the initial years. Such bonds are issued by corporates whose business model has a gestation period before the actual revenues start. Examples of a company which may issue such type of bonds include construction companies.
STEP-UP BONDS’:- These are bonds where the coupon usually steps up after a certain period. They may also be designed to step up not once but in a series too. Such bonds are usually issued by companies where revenues/ profits are expected to grow in a phased manner. These are also called as a dual coupon or multiple coupon bonds.
STEP DOWN BONDS:- These are just the opposite of Step-Up Bonds. These are bonds where the coupon usually steps down after a certain period. They may also be designed to step down not once but in a series too. Such bonds are usually issued by companies where revenues/ profits are expected to decline in a phased manner; this may be due to wear and tear of the assets or machinery as in the case of leasing.
FLOATING RATE BONDS:- Floating rate bonds are so called because they have a coupon which is not fixed but rather linked to a benchmark. For example, a company may issue a floating-rate bond as Treasury bond rate + 50 bps (100 bps = 1%), In such cases on every interest payment date, the payment will be made 0.50% more than the treasury bill rate prevailing on the fixing date.
INVERSE FLOATERS:- These types of bonds are similar to the floating rate bond in that the coupon is not fixed and is linked to a benchmark; however, the differentiating thing is that the rate is inversely related to the benchmark. In simple words, if the benchmark rate goes up; the coupon rate comes down and vice versa.
PARTICIPATORY BONDS:- A participatory bond is a bond whereby the issuer promises a fixed rate but the coupon cash flow may increase if the profit/ income levels of the company rise to a pre-specified level and may reduce when income falls below a pre-specified level; thereby the investor participates in the return enjoyed based on company revenues/ income.
INCOME BONDS:- Income bonds are similar to participatory bonds however these type of bonds do not have a reduction in interest payments if income/ revenue reduces.
PAYMENT IN KIND BONDS:- These types of bonds pay interest/coupon, not in terms of cash payouts but in the form of additional bonds.
EXTENDABLE BONDS:- Extendable bonds are bonds that allow the holder to enjoy the right to extend the maturity if required. The holder has an additional benefit in this case because if the rate of interest in the market reduces, the holder may choose to extend the tenor and enjoy the higher rate of interest in terms of coupon payment. For this benefit, the holder may enjoy the coupon rates that are usually lower than a plain vanilla bond.
EXTENDABLE RESET BONDS:- These are types of bonds which allow the issuer and the bondholders to reset the coupon rate based on the then prevailing market scenario. This is not linked to any benchmark but on the basis of renegotiation between the issuer and the bondholders. This is usually the case where bond tenor is very long.
PERPETUAL BONDS:- These types of bonds pay a coupon rate on the face value till the life of the company. Though Perpetuity means forever, bonds with maturity above 100 years are also considered to be perpetual bonds.
CONVERTIBLE BONDS:- Convertible bonds are a special variety of bonds which have an inbuilt feature of being converted to equity shares at a specified time at a pre-set conversion price.
FOREIGN CURRENCY CONVERTIBLE BONDS:- Foreign currency convertible bond is a special type of bond issued in the currency other than the home currency. In other words, companies issue foreign currency convertible bonds to raise money in foreign currency.
EXCHANGEABLE BONDS:- These bonds are similar to the convertible bonds but differ in one aspect that they can be exchanged for equity shares but not of the issuer. These can be exchanged for equity shares of another company which the issuer may have stakeholding.
CALLABLE BONDS:- Bonds that are issued with a specific feature where the issuer has the right to call back the bonds at a pre-agreed price and a pre-fixed date are called as callable bonds. Since these bonds allow a benefit to the issuer to repay off the liability before maturity, these bonds usually offer a coupon rate higher than a normal straight coupon-bearing bond.
PUTTABLE BONDS:- Bonds that are issued with a specific feature where the bondholder has the right to return back the bonds at a pre-fixed date before maturity are called as puttable bonds. Since these bonds allow a benefit to the bondholders to ask for the principal repayment before maturity, these bonds usually offer a coupon rate lower than a normal straight coupon-bearing bond.
TREASURY STRIPS:- In the US, Government dealer firms usually break down a coupon-bearing bond into a series of zero coupon bonds by considering each cash flow as a separate bond. For example, a 5-year semiannual coupon-bearing bond can be split into 10 zero coupon bonds with coupon amount as face value and 1 zero coupon bond with principal amount as the face value. The bond stripping usually is done to increase liquidity and facilitate easy tradability.
YANKEE BONDS:- A dollar-denominated bond issued in the US by an issuer who is outside the US is called as Yankee bond.
SAMURAI BONDS:- A yen-denominated bond issued in Japan by an issuer who is outside Japan is called as Samurai bond.
Shogun Bonds: A non-Yen denominated bond issued in Japan by an issuer who is outside Japan is called as Shogun bond.