Bonds are widespread in the financial market and there are various types of bonds that you can choose from when deciding to enter its market.
But before diving into the various types of bonds, you must first learn its very basic information. So, let’s now discuss what exactly a bond is.
What is a Bond?
In the simplest terms, a bond is a type of loan. As an investor, you’ll normally lend your money to the bond issuer, albeit temporarily.
In exchange for this, you’ll receive interest income at a predetermined rate or also known as the coupon rate. Also remember that your income will be delivered at predetermined times or what is commonly known as the coupon date. The bonds also have expiration dates which are known as the maturity dates. During this time, the stated par value of the bond must be returned. There are also numerous bonds that cease to exist at maturity.
Different bonds display different types of special privileges. There are bonds known as zero coupon bonds. These are bonds issued at a discount and mature at full value.
There are also bonds capable of being converted into common stocks under specific terms, dates, and prices. These are commonly known as convertible bonds.
One of the most appealing factors of bonds when looking at it from the perspective of the bond issuer is the ability to lower cost of capital. With the increased leverage, return on equity also rises.
Bond rates are provided by bond rating agencies. Those at the top are known as investment grade bonds. They have the Triple-A rated bonds, translated as being the best of the best. On the other hand, those at the bottom are known as junk bonds.
It’s taken as a general rule that the higher the investment grade gets, the lower the interest rate yield. This is mostly due to having less apparent risk involved when you own the bonds. With this, it’s believed that there is greater possibility that both your principal and interest will be repaid on time and in full.
Read more: Factors to Consider in Bonds Investment.
Different Types of Bonds
Bonds are commonly issued by various institutions and governments which also include Federal governments, state governments, and corporations.
Without further ado, here are the different types of bonds you can choose from.
Corporations are one of the major issuer of bonds. In fact, corporate bonds make up a considerable portion of the overall bond market.
There are three classifications of corporate bonds based on maturity:
- Short-term corporate: for bonds that reached maturity in less than five years
- Intermediate corporate: for bonds that reached maturity in five to 12 years
- Long-term corporate: for bonds that reached maturity in over 12 years
Large corporations can offer a great deal of flexibility, equal to the amount of debt they can issue. Basically, the limit depends of the amount the market will bear.
Corporate bonds differ from government securities in terms of having higher yields. This is mostly due to the fact that there is a higher risk of a company defaulting when compared to a government.
In the positive side, corporate bonds can also be the most rewarding fixed income investments due to the risk the investor must face. Higher credit companies will more likely carry a considerably lower interest rate compared to riskier borrowers in order to pay back their obligations.
There are various types of bonds issued by corporations:
Corporations undergoing a restructuring phase will most commonly issue this type of bonds. These bonds are given to the bondholders of an outstanding bond issue that was recognized before the restructuring.
In these cases, the obligation will be consolidated and transferred from the previous outstanding bond issue to the adjustment bond. During this process, recapitalization of the company’s outstanding debt obligations is done effectively. This can be easily accomplished by adjusting the terms in order to increase the possibility of the company meeting its obligations.
Callable Bonds (also known as Redeemable Bonds)
These bonds can be redeemed by the issuer some time prior to its maturity. It commonly happens that the company decides to refinance the debt at a lower rate of interest if the interest rates have declined since the first issuing of the bond. In cases like this, the company will recall its current bonds before reissuing them at a lower interest rate. Because of this, callable bonds will normally have a higher interest rate.
These types of bonds are capable of being converted into the issuer’s common stock at a predetermined conversion ratio. A conversion rate is used to determine the investor’s rate when it comes to converting bonds into stocks. This will help determine the number of shares an investor can receive for each bond. The conversion rate can actually vary depending on the terms of the offering.
These bonds will give the bondholder power to force the issuer to repurchase securities at specified dates even before maturity. The price for repurchase is usually set at the time of issue, and at par value. This normally works in favor of the investors, resulting on lower yields.
Bonds under this category are issued by national governments and lower levels of government. When talking at a national or federal level, these bonds are referred to as ‘sovereign debt’. They receive support from the nation’s ability to tax its citizens and to print currency.
There are different classifications of federal debt in the United States. These classifications are based on its maturity.
- Bills: those that reach maturity in less than one year
- Notes: those that reach maturity between one and ten years
- Bonds: those that reach maturity in more than ten years
The U.S. government’s marketable securities, collectively known as ‘Treasuries’, follow this guideline. They are issued as Treasury bonds, Treasury notes, and Treasury bills (T-bills).
All debt issued by the governed are referred to as “risk free” securities and are treated as extremely safe investments. Debts of other stable countries are also treated as such. However, for developing countries, debts usually come with substantial risk.
Credit rating agencies rate a country’s risk to repay dent the same way they issue rating on corporate bonds issuers. If a country has greater default risk, they it must issue bonds at higher interest rates. Doing such will increase their cost of borrowing.
There are also instances when governments issue bonds linked to inflation. In the United States, these are known as Treasury Inflation Protected Securities or TIPS.
There are various types of bonds issued by the government:
These bonds are also referred to as “munis”. They are issued by state or local government, or by government agencies.
These bonds are usually affiliated with more risks as compared to national government bonds. The risks mostly come to the possibility that, though not often, cities can go bankrupt.
One of the best advantages you can reap from municipal bonds is the freedom from federal tax. Additionally, state and local governments will most likely consider their debt as non-taxable for residents. This then render municipal bonds completely tax free, sometimes referred to as triple tax free. Due to the tax savings, yield on municipal bonds are typically lower compared to the equivalent of taxable bonds.
Zero Coupon (also known as Z-Bonds)
These bonds does not pay coupon and are instead offered at a discount at sale. Government savings bonds are also zero coupon bonds which gain value as they approach maturity.
Other Common Types of Bonds:
Collateral Trust Bonds
These include the investment holdings of the issuer as collateral.
These bonds does not involve any collateral. It has a variation known as the subordinated debenture which has junior rights to collateral.
Deferred Interest Bonds
When you’re just starting, these bonds will not have much interest to offer, or sometimes none at all. Most of the interest will show towards the end. This format is considered to be most useful for businesses that currently have little cash needed to pay interest.
Payments from these bonds are guaranteed by a third party. This can result to a lower effective interest rate for the issuer.
Your obligation, as an issuer, to perform interest payments to bond holders only needs to be fulfilled if the issuer or a specific project turns up profits. It’s also possible for the unpaid interest to accumulate if the term allows it. The amount of unpaid interest will then accumulate until there is enough income to pay the owed amount.
Real estate or issuer owned equipment provides support for these bonds.
With this type of bond, the total amount of remaining debt can gradually be reduced. Payments will be made in each successive year.
These are bonds that originate from the same issue and shares the same maturity dates. They also have a call feature which can be redeemed at an earlier date compared to other issued bonds. The call feature or call provision is the agreement made between the bond issuers and the buyers.
Term bonds include some corporate and municipal bonds that have 10-year call feature. This is the opposite of serial bonds.
Variable Rate Bonds
The interest rate paid on this type of bond is different depending on the baseline indicator. An example of these indicators is LIBOR.
There are a wide variety of bonds for you to choose from. Learn which one will work well for you and your situation. Also, make sure that you will be able to meet the qualifications by learning as much as you can about the type of bond you want to invest in.
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