Types of Bonds

Other Types of Bonds

General Categorization

Based on coupon interest rates, bonds can be classified into

• Fixed-rate bonds
  
  
• Floating rate bonds
  
  
• Zero-coupon bonds

Fixed-rate bonds have a coupon that remains constant throughout the bond's life. A variation is stepped-coupon bonds, whose coupon increases during the bond's life.

Floating rate notes (FRNs, floaters) have a variable coupon linked to a reference interest rate, such as LIBOR or Euribor. For example, the coupon may be a three-month USD LIBOR + 0.20%. The coupon rate is recalculated periodically, typically every one or three months.

Zero-coupon bonds pay no regular interest. They are issued at a substantial discount to par value so that the interest is effectively rolled up to maturity (and usually taxed as such). The bondholder receives the full principal amount on the redemption date. Zero-coupon bonds may be created from fixed-rate bonds by a financial institution separating ("stripping off") the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond may be traded separately.

Government Bond Bond of National Loan issued by the Polish National Government in 1863.

Additional Types

There are additional special classes of bonds, including:

Inflation-linked bonds (linkers) are those in which the principal amount and the interest payments are indexed to inflation. It is one type of floating rate bond. The interest rate is normally lower than for fixed-rate bonds with a comparable maturity. However, as the principal amount grows, the payments increase with inflation. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation-linked bonds issued by the U.S. government. There are also other indexed bonds. For example, equity-linked notes and bonds are indexed on a business indicator (income, added value) or a country's gross domestic product (GDP).

Convertible bonds let a bondholder exchange a bond for several shares of the issuer's common stock. In contrast, exchangeable bonds allow for the exchange of shares of a corporation other than the issuer.

Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBSs), collateralized mortgage obligations (CMOs), and collateralized debt obligations (CDOs).

Subordinated bonds have a lower priority than other issued bonds in liquidation cases. In case of bankruptcy, there is a hierarchy of creditors. First, the liquidator is paid, followed by government taxes, etc. The first bond holders in line to be paid are those holding senior bonds. After they have been paid, the subordinated bondholders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds are in bonds issued by banks and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, and the subordinated tranches later.

Perpetual bonds, also called perpetuities or "perps," have no maturity date. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries.

A registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer or by a transfer agent. It is the alternative to a bearer bond. Interest payments and the principal upon maturity are sent to the registered owner. On the contrary, a bearer bond is an official certificate issued without a named holder. In other words, the person with the paper certificate can claim the value of the bond. Often, they are registered by a number to prevent counterfeiting, but they may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets.

A serial bond is a bond that matures in installments over a period of time. In effect, a $100,000, 5-year serial bond would mature in a $20,000 annuity over a 5-year interval.

Some companies, banks, governments, and other sovereign entities may decide to issue bonds in foreign currencies because they may appear to be more stable and predictable than their domestic currency. Issuing bonds denominated in foreign currencies also allows issuers to access investment capital available in foreign markets. Some examples include:

• Eurodollar bond – U.S. dollar-denominated bond issued by a non-U.S. (European) entity.
  
  
• U.S. Yankee bond – a US dollar-denominated bond issued by a non-U.S. entity in the U.S. market.
  
  
• Samurai bond – a Japanese yen-denominated bond issued by a non-Japanese entity in the Japanese market.
  
  
• Bulldog bond – a pound-sterling-denominated bond issued in England by a foreign institution or government.
  
  
• Kimchi bond – a Korean won-denominated bond issued by a non-Korean entity in the Korean market.

Floating-rate bonds have a variable coupon equal to a money market reference rate (e.g., LIBOR) plus a quoted spread.

Floating rate bonds (FRBs) have a variable coupon equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread (i.e., quoted margin). The spread is a rate that remains constant. Almost all FRBs have quarterly coupons (i.e., they pay out interest every three months), though counter-examples do exist. At the beginning of each coupon period, the coupon is calculated by fixing the reference rate for that day and adding the spread. A typical coupon would look like three months USD LIBOR +0.20%.

In the United States, government-sponsored enterprises (GSEs), such as the Federal Home Loan Banks, the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac), are important issuers. In Europe, the main issuers are banks.

A municipal bond was issued in 1929 by the city of Kraków (Poland).

There are many variations of floating-rate bonds. For instance, some FRBs have special features, such as maximum or minimum coupons, called "capped FRBs" and "floored FRBs." Those with both minimum and maximum coupons are called collared FRBs. Perpetual FRBs are another form of FRB that is also called irredeemable or unrated and is akin to a form of capital. FRBs can also be obtained synthetically by combining a fixed-rate bond and an interest-rate swap. This combination is known as an "asset swap."

FRBs carry little interest rate risk. A FRB has a duration close to zero, and its price shows very low sensitivity to changes in market rates. When market rates rise, the expected coupons of the FRB increase in line with the increase in forward rates, which means its price remains constant. Thus, FRBs differ from fixed-rate bonds, whose prices decline when market rates rise. As FRBs are almost immune to interest rate risk, they are considered conservative investments for investors who believe market rates will increase. The risk that remains is credit risk.

Securities dealers make markets in FRBs, which are traded over the counter instead of on a stock exchange. In Europe, most FRBs are liquid, as the biggest investors are banks. In the United States, FRBs are mostly held to maturity, so the markets aren't as liquid. In the wholesale markets, FRBs are typically quoted as a spread over the reference rate.