Fixed-income security is a financial obligation of an entity that promises to pay a specified sum of money at specified future dates, sort of like a loan with interest payments. Such securities are issued by governments- central, state, municipal bodies, corporate bodies, and other financial institutions to raise capital for various purposes.
Now, fixed income securities include both debt securities and preferred stock. Debt securities include bonds, mortgage-backed securities, asset-backed securities, and bank loans.
In this blog, we'll focus on the different types of bonds. So, what are bonds?
As mentioned, bonds are debt instruments. The organization issuing or selling the bond is taking a loan from the organization buying the bond. The bond issuer promises to pay the principal amount at the maturity date and interest (in the form of coupon payments) at regular intervals post borrowing as per the terms and conditions mentioned in the bond's indenture.
The indenture is a document containing the promises of the issuer and the bondholders' rights, basically the terms and conditions of the bond in great detail. Features of a bond:
Maturity: Number of years the debt is outstanding.
Principle Value: Amount that the issuer agrees to pay the bondholder at maturity.
Coupon Rate: Interest rate the bond issuer agrees to pay at predefined intervals of time.
The global equity market's market capitalization is around $35 trillion, whereas the worldwide bond markets' market capitalization is about $130 trillion. The bond markets are less appealing than the equity markets due to the relatively lower volatility in the bond markets, but this aspect makes bond markets safer.
A risk-averse investor will prefer investing in the bond markets over equity markets. The reader should note that certain bonds- like junk bonds of corporations or bonds of politically unstable countries are risky.
Due to the safety guaranteed by the bond markets and the use of bonds in major financing activities, the bond market capitalization is humongous.
Bonds are capital market instruments. Capital market instruments are fixed-income obligations that trade in the secondary market or are bought and sold to others. Bonds are generally traded OTC (Over-The-Counter) or bilaterally since usually large institutional investors, investment banks, hedge funds, and asset management firms trade bonds.
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A government bond is a debt instrument issued by the central and state governments. Such bonds are issued to raise money to finance government projects such as those involving infrastructure development.
Typically, government bonds are considered risk-free since the government itself backs them. For the bond to default, the government would have to collapse, which is highly unlikely in developed countries and unlikely in most developing countries.
In fixed-rate bonds, the coupon rate remains constant throughout the investment period.
This rate is mentioned in the name and indenture of the bond.
Floating Rate Bonds:
The coupon is set with respect to a reference rate in floating-rate bonds, for example, MIBOR (Mumbai Interbank Offered Rate), LIBOR (London Interbank Offered Rate), + some basis points.
When the interest rate rises, fixed-rate bonds lose value, whereas fixed-rate bonds gain value if the interest rate rises. There is, however, no impact of fluctuations in interest rates on the floating rate bonds.
No coupon is paid during the life of such bonds.
Such bonds are free from reinvestment risk or the probability that an investor would not be able to reinvest the coupon payments at the current interest rate.
Sovereign Gold Bonds
RBI issues these bonds on behalf of the central government.
They are convenient substitutes for holding physical gold and are denominated in grams of gold.
The principal and coupon rate of such bonds are linked to inflation- measured as per the Consumer Price Index (CPI) or Wholesale Price Index (WPI). If CPI is used, these bonds are called Capital Indexed Bonds (CIB).
Such bonds are primarily issued for retail investors and serve to protect one's portfolio from inflation risk.
Bonds with Call/Put Options
In case that the future interest rate falls significantly below the bond's coupon rate, the bond issuer would find it beneficial to retire the bond and issue one with a lower coupon rate. Bonds with call provision or callable bonds allow the same.
The price at which the issuer retires the bond is called the call price or redemption price and is greater than the principal amount.
A bond with a put provision included in the indenture grants the bondholder the right to sell the bond back to the bond's issuer at a specified price on designated dates.
The specified price is called the put price.
As suggested by the name, such bonds are constructed for the saving purposes of resident individuals.
In India, such bonds pay an extremely safe 7.75% return per annum.
Government agency bonds or agency bonds are issued by government-backed agencies for specific goals. They offer relatively more outstanding coupon payments but are slightly riskier than government bonds.
Public Sector Bonds: These bonds are issued by Public Sector Units (PSU) or the firms, with the government being the majority stakeholder for the country's growth and expansion purposes.
Municipal bonds or muni bonds, in short, are bonds issued by municipal corporations. Municipal corporations are local government bodies that use these bonds to finance socio-economic projects like the ones involved in building public infrastructure, including roads, bridges, hospitals, schools, etc., in a community.
These bonds can be broadly divided into:
General Obligation Bonds:
These bonds are used for infrastructure financing and other general needs in a community.
The repayment and interest payment of such bonds are processed through the municipality's revenue in established projects and taxes.
These bonds are raised for special projects.
The repayment and interest payment of such bonds is processed through the revenue generated from the particular project for which financing is done, and so here, the risk component is more.
Like the government, government-backed agencies and municipal corporations need funding for various purposes; corporations also require funds for operations and expansion purposes.
Corporate bonds are fixed-income securities issued by industrial corporations to raise funds to invest in plants, equipment, or working capital.
They can be categorized on the basis of:
credit quality (measured by the ratings assigned by rating agencies)
maturity (short term, intermediate-term, or long term)
component of the indenture (sinking fund or call feature)
Secured Bonds: Secured bonds are the most senior bonds in a firm's capital structure and have the lowest risk of default.
Mortgage Bonds: Mortgage bonds are backed by specific assets such as land and buildings. In the case of bankruptcy, the proceeds from the sale of these assets are used to pay off the mortgage bondholders.
Collateral Trust Bonds: Collateral trust bonds are a form of mortgage bond except that the assets backing the bonds are financial assets, such as stocks, notes, and other high-quality bonds.
Equipment Trust Bonds: Equipment trust bonds are mortgage bonds secured by specific pieces of transportation equipment, such as locomotives and airplanes.
Debentures: Debentures are based on promises to pay interest and principal; they pledge no collateral if the firm does not fulfill its promise. This means that the bondholder depends on the success of the borrower to make the promised payment. But, in case of bankruptcy, debenture owners have a claim on the assets of the firm.
Subordinated Bonds: Subordinated bonds are similar to debentures, but, in the case of bankruptcy, subordinated bondholders have a claim to the firm's assets only after the firm has satisfied the claims of all secured and debenture bondholders.
Income Bonds: Income bonds have predetermined interest payment dates, but the interest is paid only if the issuers earn the income to make the payment by the predetermined dates.
Convertible Bonds: Convertible bonds are just like other bonds, but the bondholder's indenture gives the bondholder the option to exchange the firm's common stock with the bond. Due to this added provision, convertible bonds pay lower coupon payments but are usually quite attractive for the bondholders.
(Must check: What are derivatives?)
Apart from the types of bonds listed above, there are other types of bonds, including:
Bonds raised by governments in adverse situations: War Bonds, Climate Bonds, etc.
Bonds made by introducing special provisions in indenture: Step-Up Bonds, Step-Down Bonds, Sinking Fund Bonds, Extendable Bonds, Extendable Reset Bonds, etc.
Bonds used for international investing: Eurobonds, Yankee Bonds, Samurai Bonds, etc.
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