Categories and Types of Bonds Explained

UTC by Adedamola Bada · 8 min read
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Categories and Types of Bonds Explained

One common borrowing option which is used by governments and corporations throughout the whole world is called bonds. Find its types and categories explained below.

A lot of corporations and governments wouldn’t have attained what they have today without one form of borrowing or another. One common borrowing option these entities often use is called bonds. Take the government, for instance, all tiers of government have projects to complete like the building of schools, roads, dams and lots more. All these require funds and bonds serve an excellent avenue to raise them.

The same can be said about corporations. In their case, they borrow for a number of reasons like business expansion, acquiring expert hands, research and development or to venture into new profitable projects. Since some of their projects are capital intensive, banks may not have enough money to support them, which makes them turn to bonds. Bonds create an opportunity for individuals to invest in these companies, thereby assuming the role of a lender.

What is Bond?

A bond can be referred to as a fixed income tool used by governments or corporations to acquire loans from individual lenders. A bond is usually between two people, a lender and a borrower. Those who own bonds are known as the issuer, creditor or debt holders.

Every bond has important details for authenticity, and they include the expiration date, which is when the loan must be repaid to the lender as well as the agreement of interest rate between the borrower and the lender.

Bond Characteristics

A lot of bonds share similar characteristics, such as:

Face Value

This is what a bond is expected to amount to when it matures. All calculations on interest rates also find their basis here. For example, the premium attached to a bond is $2,090, and an investor purchased it at the same price. After some time, the price fell to $1,980, which another investor purchased due to the discount. At the end of the bond’s maturity period, the same face value of $2,000 will be paid to the two investors.

The Coupon Rate

This has to do with the interest rate the bond issuer has to pay with respect to the bond’s face value. It is usually denoted as a percentage. For instance, when a 3% coupon rate is attached to a bond, the bondholders should expect $30 yearly, assuming the face value is $1000. The amount is obtained by multiplying the coupon rate with the face value of $1000.

Coupon Dates

These are dates in which the lender should expect interest payments from the company or government. Payments have no specific interval, but the standard is considered to be semiannual.

The Maturity Date

On this date, the bond is considered mature, and the face value must be paid to the bondholder by the bond issuer.

The Issue Price

This is the price tag of a bond for sale.

Categories of Bonds

Below you may find the key categories of bonds explained.

Government Bonds

These are bonds issued by governmental bodies; an example is the U.S. Treasury. The Treasury publishes different types of bonds, namely Bills, Notes and Bonds. Bills are those that mature within a year or less. Notes have a lifespan of 1-10 years before they’re considered mature. Bonds are those that mature from 10 years and above.

U.S. Treasury Bonds

These bonds come from the Federal government to aid the country’s project development, and they are credit-risk free. However, they don’t amount to much in terms of yield. They also have their strengths which are seen during economic downturns. In such a time, they fare better than the higher-yielding bonds and the interest from them enjoys state income tax exemption.

Corporate Bonds

These are bonds sold by companies. In order to fund one project or another, companies issue bonds to raise capital. Below are two types of corporate bonds:

  • Investment-grade corporate bonds

These are issued by companies that have a valid and verifiable high-profit record. They are rated at least triple-B from credible rating authorities like Standard & Poor’s and Moody’s Investors Service. There is a very slim chance of default with this bond.

  • High-yield corporate bonds

Bonds from companies under this category usually have ratings lesser than triple-B because of the company’s weak balance sheets. They are also prone to default. The prices of bonds in this class reflect the performance of the company.

Agency Bonds

They originate from federal agencies like the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corp. (Freddie Mac) and the Government National Mortgage Association (Ginnie Mae). Interest earned by the bonds is subject to taxes from the state and federal governments, and they have minimal credit risk.

Also, the yields from agency bonds surpass that of Treasury because they are not considered full-faith-and-credit obligations of the U.S. government.

Municipal Bonds

Also known as munis, these are bonds with origin from U.S. States and local governments. They are not accessible to just anyone, and their interest is not subject to any form of tax. There are two types of municipal bonds, namely: the high-yield and investment-grade bonds.

Due to the taxes imposed on taxable yields, their returns are higher than that of munis as a form of compensation to investors.

Foreign Bonds

These are different types of securities. A number of them are dollar-denominated, but on average, foreign bonds are known to be denominated by foreign currencies.

Interest and principal payments with foreign-currency-denominated bonds are made using a foreign currency. The exchange rate will determine their worth in dollars. With this type of bond, exchange rates have the upper hand more than interest rates in determining its overall performance.

Types of Bonds

Investors have a wide range of bonds to select from. These bonds can be differentiated by interest type or rate, coupon payment, and many more attributes.

Zero-Coupon Bonds

Another name for this type of bond is accrual bond. It is characterized by long maturity dates, an extreme discount price and holders of the bond are not entitled to coupon payments. Upon maturity, its full value is paid. Also, this type of bond is more unstable in price compared to coupon bonds. They are issued by the state and local government, corporations and the U.S. Treasury.

Convertible Bonds

Bonds that fall within this category can be switched into stocks according to the desire of bondholders. This is made possible by an inlaid option that gives bondholders the right to alter the nature of their securities. For instance, a cash-strapped company about to carry out a $1 million project could raise funds by selling 12% coupon bonds with ten years of maturity.

However, if there are investors that are interested in bonds with an 8% coupon with the possibility of converting them into stocks during a high yield period, the company might be persuaded to issue such bonds instead.

Callable Bonds

Companies employ this type of bond because of its inbuilt benefits that allow the company issued bonds to be recalled even before it matures. What this means is that a company may create a $1 million investment bond to have a ten years maturity period with a coupon of 10%. After selling the bonds to investors, the company has the authority to recall them. Certain factors may influence this action, such as a decline in the rate of interest or an improvement in the credit rating of the company.

These economic factors may provide the company with an opportunity to sell new bonds for a reduced coupon rate of, say, 8%. Therefore, the previous bonds will be rendered invalid, and bondholders will be forced to take back their principal. After the company recalls the previous bonds, it may go-ahead to issue fresh bonds, and this time at a coupon rate lower than before.

Callable bonds are more beneficial to the company than the investor because the company may decide to go back on its agreement at any moment, so long as it works in its interest. For this reason, callable bonds are regarded as less valuable compared to non-callable bonds with the exact coupon rate, credit rating, and maturity.

Puttable Bonds

This is the reverse of callable bonds in which investors have the power to return the bond they previously purchased from a company, as they deem fit. It doesn’t matter whether the bond is mature or not, as long as the investor feels the need to sell, the company is obligated to repurchase it. Investors favor this bond the most because it works in their best interest.

For example, if a bondholder feels that his investment is no longer safe due to a possible rise in the interest rate or a decline in the bond value, the investor has the right to return the bond to the issuing company to take back his principal.

Puttable bonds are usually more valuable than non-puttable bonds because bondholders find it to be a better investment.

Summary

Not all bonds mature at the same time. Some have a maturity limit of 1 year or less, while others can exceed ten years. They are also greatly influenced by inflation, credit risks, and interest rates.

Whenever there is a surge in the rate of interest, bond prices take a plunge. However, if a bond is not held to term, the bondholder runs the risk of receiving less than it was purchased, but sometimes, due to favorable market conditions, it may be worth more.

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