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Investment - Types of Bonds
Fixed-Rate Bonds
Fixed-rate bonds are the major type of debt securities issued by enterprises and governments. A fixed-rate bond has a defined life that ends on the bond’s maturity date, has a coupon rate that does not change over the life of the bond, and has a par value that does not change. That is, fixed-rate bonds pay fixed, periodic coupon payments during the life of the bond and a final par value payment at maturity.
Floating-Rate Bonds
Floating-rate bonds, commonly referred to as variable-rate bonds or floating-rate notes (FRNs) or floaters, are identical to fixed-rate bonds except that the coupon rate on floating-rate bonds increases over time.
The coupon rate of a floating-rate bond is frequently linked to a market reference rate, such as the risk-free rate or other benchmark rate.
The variable rate reflects the reference rate and the riskiness (or creditworthiness) of the issuer at the time of issuing. The floating rate is equal to the reference rate plus a percentage that is a function of the issuer’s creditworthiness and the bond’s attributes.
The percentage above the reference rate is termed the spread and normally remains constant over the life of the bond.
In other words, for an existing issue, the spread used to and normally remains constant over the life of the bond.
In other words, for an existing issue, the spread used to compute a floating-rate bond’s coupon payment does not alter over the bond’s life to reflect any change in creditworthiness that occurs after issue. But the reference rate does alter over time with changes in the level of interest rates in the economy.
Floating rate = Reference rate + Spread
In bond markets, the practice is to refer to percentages in terms of basis points. One hundred basis points (or bps, pronounced ‘bips’) equal 1.0%, so one basis point is equal to 0.01%, or 0.0001.
Therefore, rather than describing a floating rate as the applicable reference rate + 0.75%, the floating rate would be presented as the reference rate plus 75 bps.
A floating-rate bond’s coupon rate will change, or reset, at each payment date, often every quarter. Floating-rate coupon payments are paid in arrears — that is, at the conclusion of the period on the basis of the level of the reference rate set at the beginning of the period.
On a payment day, the coupon rate is set for the next period to reflect the current level of the reference rate plus the stated spread. This new coupon rate will decide the amount of the payment at the next payment date.
The following example illustrates the effect of changes in a reference rate on coupon rates and coupon payments for a floating-rate bond.
Example: Floating-Rate Bonds
On 31 March, a UK company raises GBP2 million by issuing floating-rate notes with a maturity of nine months.
The reference rate is the three-month Sterling Overnight Index Average (SONIA).
The coupon rate is SONIA plus 140 bps (1.40%).
Note that although though it is labeled three-month SONIA, the rate given is an annual rate. It is usual practice to quote interest rates as an annual rate. Therefore, the total rate (SONIA + 1.40%) must be divided by four to calculate the quarterly coupon payment. The coupon rate is reset every quarter.
The exhibit below illustrates the three-month SONIA rate at the beginning of each quarter and the total coupon payment made each quarter by the corporation.
Fixed-Rate Bonds
Fixed-rate bonds are the major type of debt securities issued by enterprises and governments. A fixed-rate bond has a defined life that ends on the bond’s maturity date, has a coupon rate that does not change over the life of the bond, and has a par value that does not change. That is, fixed-rate bonds pay fixed, periodic coupon payments during the life of the bond and a final par value payment at maturity.
Floating-Rate Bonds
Floating-rate bonds, commonly referred to as variable-rate bonds or floating-rate notes (FRNs) or floaters, are identical to fixed-rate bonds except that the coupon rate on floating-rate bonds increases over time.
The coupon rate of a floating-rate bond is frequently linked to a market reference rate, such as the risk-free rate or other benchmark rate.
The variable rate reflects the reference rate and the riskiness (or creditworthiness) of the issuer at the time of issuing. The floating rate is equal to the reference rate plus a percentage that is a function of the issuer’s creditworthiness and the bond’s attributes.
The percentage above the reference rate is termed the spread and normally remains constant over the life of the bond.
In other words, for an existing issue, the spread used to and normally remains constant over the life of the bond.
In other words, for an existing issue, the spread used to compute a floating-rate bond’s coupon payment does not alter over the bond’s life to reflect any change in creditworthiness that occurs after issue. But the reference rate does alter over time with changes in the level of interest rates in the economy.
Floating rate = Reference rate + Spread
In bond markets, the practice is to refer to percentages in terms of basis points. One hundred basis points (or bps, pronounced ‘bips’) equal 1.0%, so one basis point is equal to 0.01%, or 0.0001.
Therefore, rather than describing a floating rate as the applicable reference rate + 0.75%, the floating rate would be presented as the reference rate plus 75 bps.
A floating-rate bond’s coupon rate will change, or reset, at each payment date, often every quarter. Floating-rate coupon payments are paid in arrears — that is, at the conclusion of the period on the basis of the level of the reference rate set at the beginning of the period.
On a payment day, the coupon rate is set for the next period to reflect the current level of the reference rate plus the stated spread. This new coupon rate will decide the amount of the payment at the next payment date.
The following example illustrates the effect of changes in a reference rate on coupon rates and coupon payments for a floating-rate bond.
Example: Floating-Rate Bonds
On 31 March, a UK company raises GBP2 million by issuing floating-rate notes with a maturity of nine months.
The reference rate is the three-month Sterling Overnight Index Average (SONIA).
The coupon rate is SONIA plus 140 bps (1.40%).
Note that although though it is labeled three-month SONIA, the rate given is an annual rate. It is usual practice to quote interest rates as an annual rate. Therefore, the total rate (SONIA + 1.40%) must be divided by four to calculate the quarterly coupon payment. The coupon rate is reset every quarter.
The exhibit below illustrates the three-month SONIA rate at the beginning of each quarter and the total coupon payment made each quarter by the corporation.
Inflation-Linked Bonds
An inflation-linked bond is a particular sort of floating-rate bond. Inflation-linked bonds feature a provision that adjusts the bond’s par value for inflation and thereby protects the investor against the consequences of inflation. Inflation will often lower an investor’s purchasing power from bond cash flows. Changes to the par value lessen the effects of inflation on the investor’s purchasing power from bond cash flows.
For most inflation-linked bonds, the par value — not the coupon rate — of the bond is modified at each payment date to reflect changes in inflation (which is normally monitored by a consumer price index).
The bond’s coupon payments are adjusted for inflation since the fixed coupon rate is multiplied by the inflation-adjusted (higher) par value.
Examples of inflation-linked bonds are Treasury Inflation-Protected Securities (TIPS) in the United States, index-linked gilts in the United Kingdom, and iBonds in Hong Kong.
Because of the inflation protection afforded by inflation-linked bonds, the coupon rate on an inflation-linked bond is often lower than the coupon rate on a fixed-rate bond with otherwise equivalent characteristics.
Zero-Coupon Bonds
As with fixed-rate and floating-rate bonds, zero-coupon bonds have a finite life that ends on the bond’s maturity date. But zero-coupon bonds do not offer periodic interest payments during the life of the bond. The only cash flow offered by a zero-coupon bond is a single payment equal to the bond’s par value that is paid on the bond’s maturity date.
Zero-coupon bonds are often issued at a discount to the bond’s par value — that is, at an issue price that is lower than the par value. Thus, the investor’s return for owning the bond is the difference between the issue price and the par value payment received at maturity.
Many debt securities issued with maturities of one year or less are issued as zero-coupon debt securities.
For example, Treasury notes having maturities of one year or less issued by the US government are issued as zero-coupon securities.
In rare situations, firms and governments issue zero-coupon bonds that have maturities of greater than one year. Because of the risk inherent when the only payment is the payout at maturity, investors are frequently reluctant to buy zero-coupon bonds with long periods to maturity. If they are willing to do so, the projected return must be quite high compared to the interest rate on coupon-paying bonds, and many issuers are reluctant to pay such a high cost for borrowing.
The following example describes the issue of a 20-year zero-coupon bond.
Example: Zero-Coupon Bonds
Suppose a corporation issues zero-coupon bonds, each with a par value of EUR1,000. Further assume that, at issuance, investors agree to pay EUR268.31 for each bond. Thus, the investor’s projected return for buying the bond will be €1,000 – €268.31 = €731.69, to be received on the bond’s maturity date.
This example explains why investors often favor high rates of projected return for zero-coupon bonds with long terms to maturity.
An inflation-linked bond is a particular sort of floating-rate bond. Inflation-linked bonds feature a provision that adjusts the bond’s par value for inflation and thereby protects the investor against the consequences of inflation. Inflation will often lower an investor’s purchasing power from bond cash flows. Changes to the par value lessen the effects of inflation on the investor’s purchasing power from bond cash flows.
For most inflation-linked bonds, the par value — not the coupon rate — of the bond is modified at each payment date to reflect changes in inflation (which is normally monitored by a consumer price index).
The bond’s coupon payments are adjusted for inflation since the fixed coupon rate is multiplied by the inflation-adjusted (higher) par value.
Examples of inflation-linked bonds are Treasury Inflation-Protected Securities (TIPS) in the United States, index-linked gilts in the United Kingdom, and iBonds in Hong Kong.
Because of the inflation protection afforded by inflation-linked bonds, the coupon rate on an inflation-linked bond is often lower than the coupon rate on a fixed-rate bond with otherwise equivalent characteristics.
Zero-Coupon Bonds
As with fixed-rate and floating-rate bonds, zero-coupon bonds have a finite life that ends on the bond’s maturity date. But zero-coupon bonds do not offer periodic interest payments during the life of the bond. The only cash flow offered by a zero-coupon bond is a single payment equal to the bond’s par value that is paid on the bond’s maturity date.
Zero-coupon bonds are often issued at a discount to the bond’s par value — that is, at an issue price that is lower than the par value. Thus, the investor’s return for owning the bond is the difference between the issue price and the par value payment received at maturity.
Many debt securities issued with maturities of one year or less are issued as zero-coupon debt securities.
For example, Treasury notes having maturities of one year or less issued by the US government are issued as zero-coupon securities.
In rare situations, firms and governments issue zero-coupon bonds that have maturities of greater than one year. Because of the risk inherent when the only payment is the payout at maturity, investors are frequently reluctant to buy zero-coupon bonds with long periods to maturity. If they are willing to do so, the projected return must be quite high compared to the interest rate on coupon-paying bonds, and many issuers are reluctant to pay such a high cost for borrowing.
The following example describes the issue of a 20-year zero-coupon bond.
Example: Zero-Coupon Bonds
Suppose a corporation issues zero-coupon bonds, each with a par value of EUR1,000. Further assume that, at issuance, investors agree to pay EUR268.31 for each bond. Thus, the investor’s projected return for buying the bond will be €1,000 – €268.31 = €731.69, to be received on the bond’s maturity date.
This example explains why investors often favor high rates of projected return for zero-coupon bonds with long terms to maturity.
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