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D. Types of Bonds

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Based on Issuer

 
Governments
 
Governments are the largest issuers of bonds in the world. Government bonds have more or less a zero risk of default and this, combined with the large volume issued and the uniform nature of the structure of government bonds means they can be easily bought and sold – they are what is called, liquid. This also means they provide a benchmark for other types of bond issue. Government bonds provide what is called a ‘riskless rate of return’. This is a useful guide to what sort of return a bond has to offer as the level of default risk rises. For example, if a French governmental bond has a zero risk of default, what risk of default does a bond issued by a French corporation have in comparison? A final point to note about ‘governments’ is that they are an actively traded market, unlike other types of bond issue, which tend to be passively held. This too stems from the volume and sameness of what is issued – i.e. the liquidity of the market.

 

Corporates
 
The corporate bond market is the second largest in terms of volumes. Issuers can place paper in their own domestic market or they may widen their investor base by issuing in a foreign market or in the international market - the Euromarket - in any number of currencies. Investors require a credit analysis to decide upon the suitability of the credit premium offered above the corresponding government issues of comparable maturity - as reflected in the yield spread- to determine the attractiveness of the investment opportunity. The corporate bond market is tiered in much the same way that the equity market is. However, the equity market is a lot more intuitive; you have got big companies, medium size companies, small companies, start-up companies and so on - and different market segments are deemed more or less risky on the basis of their market capitalisation. In the bond markets - because the credit rating agencies actually assign a credit rating to each bond - this sort of tiering is much more formalised. You know what level of credit risk is attached to a particular corporate bond because the rating agency's rating tells you. The general rule is; the higher the risk, the higher the return.  Once you get involved with high yield bonds (formally known as 'junk', now known as 'non-investment grade'), you are dealing with a lot more risk.

 

Based on Maturity
 
Shorts:
bonds with lives up to 5 years
Mediums:
bonds with lives from 5 to 15 years
Longs:
bonds with lives over 15 years

 

Based on Credit Rating
 
-Investment grade:  Bonds which are a very high level of credit quality, considered to have little risk of default.  BBB- and higher

-Non investment grade: The probability that the company will repay its issued debt is deemed speculative BB+  and lower

Please see section G, Credit ratings for further details on rating scale 

 

Based on Coupon
 
Zero Coupon Bonds
 
A zero coupon bond is a bond paying no coupon at all during its life. We have already said that a bond is effectively a loan. So if you don’t get any interest on your loan where is the return?

Well, with a zero coupon bond all of the return for the bond holder is achieved in the form of the repayment of principal at a value of par (100% of face value) at the maturity date.

In order to achieve a positive return the bond is issued at a discount to its face value, the return being the capital gain represented by the difference between the value at the time of purchase and the face value at maturity.

Zeros are suitable for investors who wish to avoid coupon payments. Why might an investor want to do this?

A. No reinvestment risk: Reinvesting coupon income is time-consuming and it also exposes investors to reinvestment risk - the uncertainty of investment returns on the future coupon income stream. Zeros reduce the effort of portfolio management and there is no reinvestment risk.

B. Tax efficiency: Zeros may also be tax efficient relative to straights.

If the capital gains tax rate is lower than the income tax rate a tax saving is possible. Unfortunately, many tax regimes now take a zero's yield to maturity (purchase price - par value) and annualise the implied capital gain to calculate a notional annual coupon rate which is then treated as income and taxed accordingly.

But investors may still be able to defer taxable income to a period of lower tax rates.

C. Leverage: Long term investors and speculators may also be attracted by the leverage offered by zeros. The initial capital outlay is low relative to the certain future payment at maturity.

D. Price volatility: Speculative investors are attracted by the price volatility of zeros.

Because a zero's yield is determined purely by the level of discount to par value, for any change in market interest rates, price will have to move more than for a straight bond to realign the instrument's yield to new market rates.

Set against these advantages, zero coupon bonds have some negative characteristics too.

A. Default risk: There is no higher level of default risk intrinsic to a zero. However, because a straight bond provides much (or all) of its return as income during its life, whereas a zero has to provide all investment returns in one payment at maturity default with a zero is that much more serious for the investor.

B. Price volatility: Price volatility, while attractive to speculators, does increase the instrument's market risk.

 

Fixed Coupon Bond
 
A fixed coupon bond is a bond with a fixed coupon (interest) rate, as opposed to a floating rate note and has a predetermined interest rate.

 

Floating Rate Notes
 
A floater is a debt security whose coupon rate is reset at designated dates based on the value of some designated reference rate. The coupon is usually set as :

Coupon rate= Reference rate +/- quoted margin

The most common reference rates are LIBOR, Treasury bill yield and EURIBOR.

 

Step-up Coupon Bonds
 
A bond with interest coupons that change to predetermined levels on specific dates. Thus, a stepped coupon bond might pay 9% interest for the first 5 years after issue and then step up the interest every fifth year until maturity. Issuers often have the right to call the bond at par on the date the interest rate is scheduled to change. Also called dual coupon bond, rising-coupon security, and step-up coupon security.

 

Based on Where It Is Issued
 
Bonds may be issued  domestically ( A Turkish corporate  borrowing in the Turkish market ) or globally , where they usually would  be considered as eurobond.

A Eurobond is an international bond that is denominated  in a  currency not native to  the issue market. For instance if a Japanese firms  issues a USD denominated  bond in  Luxembourg , that would be considered as Eurobond. Eurobonds are usually attractive for issuers and investors as they  are not subject to any domestic regulation or constraint. (e.g tax regime)

 

Other
 
Convertible Bonds
 
Convertible is an adaptation of a straight bond issue which gives an investor the ability to convert the bond into a specified number of shares of the same issuer at a predetermined price. A variation on the convertible bond is the exchangeable bond, which gives the investor the ability to convert the bond into a specified number of shares of a different issuer at a predetermined price.

The price behavior of a convertible is more complex than for a straight bond or for equity because a convertible is effectively a hybrid of both these instruments.

Generally speaking, when the issuer's equity is trading well below the conversion price, a convertible is effectively seen as a straight bond, with a characteristic inverse relationship between price and yield.

But when the issuer's equity is trading around or above the conversion price, the instrument becomes quasi-equity. Its status as a bond becomes irrelevant as it's value is now dictated by the stock market not the bond market. So it no longer exhibits the characteristic bond price/yield relationship.

Looking at this in diagrammatic terms, you can see that the closer the stock price gets to the conversion price the greater the divergence between the instruments convertible value and its pure investment (bond) value; and the more the instrument exhibits the linear characteristics of the relationship between the pure conversion value and the stock price.

Attractions to Investors

The attraction to investors of convertibles is the future potential for capital gain in equity markets, whilst in the meantime receiving regular income higher than the company's current gross dividend payout.

In falling equity markets, convertibles are better investments than the underlying equity as share price falls are limited by the fixed features of the straight bond, so in a falling market convertibles typically offer greater income and less capital loss.

Naturally, as a debt instrument, a convertible provides greater investor protection than equity in the event of issuer liquidation.

So the market for convertibles tends to be mainly cautious equity investors.

Investment Risks

If the issuer's share price does not rise as the investor expected, the overall yield on the debt will be lower than that obtainable from an equivalent straight bond.

But this is an 'opportunity loss' rather than a book loss.

Default risk is usually higher than for straights, as convertibles are usually subordinated to non-convertible debt.

Thus lower coupon and higher credit risk means that the prospects for either the entire equity market or for the issuer in particular, must look good for a convertible to be attractive.

If the convertible is issued at the top of a generally rising stock market - as is common - conversion will typically be unprofitable for a number of years, so the investor is holding a security yielding below comparable straight bonds but with a lower credit rating.

 

Callable Bonds
 
A callable bond is a bond which the issuer can decide to redeem before its stated maturity date. A call date and a call price are always given. You face a risk with a callable bond that it will be redeemed if its stated coupon is higher than prevailing rates at the time of its call date. If that happens, you won't be able to reinvest your capital in a comparable bond at as high a yield.

In periods of rising interest rates callable bonds will behave similarly to non-callable bonds. This is because when interest rates are rising there is very little chance of the issuer exercising the call.

However, when interest rates are falling a callable bond will significantly underperform a non-callable bond - that is its price rather than rising, may fall - because of the increased possibility of the issuer calling the bond.

 

Puttable Bonds
 
Under the terms of a puttable bond the investor has the right to demand early repayment of principal. The put option is usually exercisable on specified dates.

Puts address investor risk: that is, the risk that interest rates will rise after bond purchase, making the future value of the bond's coupon cash flows relatively less valuable.

The value of the put option is that, in high interest rate environments, investors exercising their option to have principal repaid can reinvest at a higher interest rate. Bondholders are normally prepared to pay for the protection provided by puttable bonds by accepting a lower yield relative to a non-puttable bond.

The price behavior of puttable bonds is the inverse of that of a callable bond. Here, where there are falling interest rates - so a rising price - the lines representing the puttable and non-puttable bonds behave in the same way. This is because when interest rates are falling there is very little chance of the investor exercising the put.

However, when interest rates are rising a puttable bond will significantly outperform a non-puttable bond - that is its price rather than falling, may rise - because of the increased value to investors of holding the put.

 

Sinking Fund Provision
 
In A sinking fund provision is pre determined percentage (sinking factor) of the outstanding bond nominal is redeemed. So at maturity there is only a small amount of principal left outstanding. Issuers must normally buy back bonds at par. Due to the fact that the outstanding amount is reduced during the life of the bond, the coupon payment would also be reduced by the sinking factor during the life time of the bond.

Example: Gazprom 5.625 7/22/2013 , Sinking fund bond
 
 
If as an investor you were to buy this bond with settlement date 14/4/2010, you would be subject to 0.243467118 sinking fund factor for the period. Let’s assume you purchased this bond at the clean price of 103.625 and 1 Million Nominal value, you would be paying:
 
Principal payment = 103.625*1,000,000/100*0.243467118=252,292.80
Accrued Interest Payment = (82 days accrued interest) 1,000,000*82/360*0.243467118