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Bond Types

Bonds

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There are an extremely large variety of bonds. All the bond types have a contractual property which defines them, and some of them overlap. It should be noted that each type of bond is not always fit for your investment. Whether or not a bond should be purchased depends on your personal financial situation. For example, if you are trying to build a bond portfolio which provides you with monthly financial income, you should not be investing in zero coupon bonds. Those bonds pay interest and face value only at maturity, negating your purpose for investment. This is one of many potential personal situations which limit your investment selection.

Debenture

The first and most basic bond type is the Debenture, or Straight Bond. This bond is a fixed income bond, which pays set amounts of interest at set intervals periodically following the date of issue. The issuer must repay the face value, or par value, at the specific maturity date. This sounds exactly like most bonds function, but every bond does not follow this characteristic.

Perpetual

Debentures, or straight bonds, have a maturity date. Some other bonds, known as a Perpetual Bond, do not have a maturity date. Perpetual bonds last forever unless the Issuer calls them, or you agree to sell them back to the issuer. Certain perpetual bonds have extremely long maturities and are merely ultra-long term bonds. Preferred shares, which pay dividends endlessly until/unless they are called or revoked by the issuing firm, function similarly to Perpetual Bonds. A key difference is that issuers of preferred shares have the option to pay dividends. If preferred shares do not pay dividends, the issuer cannot pay common shareholders dividends until all preferred shareholders are paid, with other potential restrictions. They can temporarily save money by halting payments and resume at a later desired date. Perpetual Bonds must pay the interest due to you on the dates due without interruption, unless the perpetual bond contract specifies otherwise.

Callable

The Callable bond functions similar to a normal debenture, with a caveat. The issuer can rescind the bond at any time; this is known as a “call”. When a call occurs, the bond is returned to the issuer, and you are paid the “call price”. The call price is not always the same as the market price of the bond. Usually the call price is higher. The difference is known as the call premium. They are not paid the interest between the call date and the maturity date. The payments after the call date are lost to you forever. Due to these reasons you should pay less for callable bonds versus straight bonds of the same yield or maturity. To counter this damaging call risk, callable bonds usually come with a deferment period. The deferment period blocks the issuer from calling the bond until the period ends.

Callable bonds typically have the risk of being called if interest rates decrease. A decrease in interest rates means that an issuer can reissue bonds at lower rates. They will call bonds that were substantially higher than the new rate before the decrease, and reissue bonds that are only slightly higher than the new rate after the decrease. This saves them money paid long term in interest. They often issue new bonds at the lower rates first… and use that money received to retire the high rate bonds. “Non-refundable” bonds can only be called if the issuer can repay the bond with money generated by sales. This counteracts issuers manipulating falling rates by issuing new bonds to pay call premiums for old bonds.

Put-able

Put-able bonds remove the right to call from issuers, and give it to you. These bonds give you the ability to sell the bond back to the issuer at your leisure on certain dates. If interest rates rise above the value of the bonds interest rate, you can sell the bonds back and reinvest at higher rates. If rates fall you can keep their bond for the time being.

Zero-Coupon

While bonds typically pay interest at set dates between the issue date and the maturity date, not all bonds do. Zero-Coupon Bonds pay no interest at all between the date of issue and the maturity date. Zero Coupon bonds are issued at a value substantially less than their par value, and mature at full par value. The difference between the issue price and the maturity price is the par value. This increases the amount of certainty found in the investment, since the purchaser of a zero-coupon bond does not have to worry about reinvesting the interest payments every six to twelve months at higher or lower rates.

There are downsides. Your zero coupon bonds may be taxed on the interest they will not receive until the bond matures. You should always check their tax laws to determine if the interest from zero coupon bonds is taxed only at maturity or annually. If taxed annually, the investment will be cash flow negative, until the interest is received at maturity. If you buy a zero-coupon bond, you must be extremely confident the issuer will not default before the maturity date. You will only receive interest and principal at the end of the bond’s term.

STRIPS & Convertibles

A certain class of bond creates other investments. STRIPS (Separately Registered Interest and Principal of Securities) are bonds which convert each interest payment into a new investment security. Whenever you would receive a new interest payment, you receive a security. Typically, the new securities are Zero Coupon bonds, which will only pay interest at the maturity of the bond. A STRIP (or security on interest payment bond) is usually offered by governments, or created by investment banks.

Convertible bonds also create another investment. While STRIPS create investment when they pay interest, convertible bonds create shares at the bond owner’s option. They usually create common shares at a specific ratio stated in the bond’s contract or prospectus. The conversion value states the exchange ratio of shares per bond. The prospectus also states a call or conversion date. Before the stated date the option to convert cannot be exercised. You exercise the conversion when the value of shares exceeds the value of the interest and face value you are likely to receive. You may then sell the shares or hold them to see if the price will increase further before selling. If the shares are not immediately sold, you risk holding shares when prices decrease and selling at a loss.

Adjustable

Unlike debentures, Adjustable Bonds have variable interest rates. These rates are not fixed and vary based on short term interest rates. This change only occurs once per year. The formula of the change is written in the prospectus or bond contract. There are several factors that issuers can use as the base for the change. As an example: A step-up note, will increase based on a specifically indicated factor noted in the prospectus. An inflation adjusting bond will increase with the price index each year, and protects against the erosion of real value over time.

Floating & Inverse Rate

The first type of adjustable bond is a Floating Rate Bond. These adjust interest payments to the market’s rates, typically short term. The bond’s rate of payment will constantly adjust to the rate of the specific bill, and then add on an additional percentage value. The result is a bond constantly in line with that specific bill’s rate. This can create issues. If the rate rises, it does not mean the bond’s issuer is automatically able to meet the payments of the new rate. The rate does not adjust to issuer’s ability to meet the bond contract’s demands.

The Inverse Floating Rate bond acts opposite to a Floating Rate bond. While Floating Rate bonds increase with market rates, Inverse Floating Rate Bonds decrease. If the floating rate rises, the bond rate falls, and vice versa. As a result, prices are increasingly sensitive to market movements. If the rate falls you benefit from having a bond above rates, and the rate further increases. If the rate rises, you suffer from having a bond below rates, and the rate falls further. This drives down the desire to own these bonds, and value decreases are worsened.

Indexed

Indexed bond are adjustable bonds whose returns are tied into the price level of inflation, or the value of a commodity. As inflation or commodity value increases the rate of the attached bond increases. When attached to the inflation rate, the value of the bond is real rate risk-free if it adjusts the bond’s par value to price increases. Typically, the par value adjusts to inflation and paid interest changes based on the new par value. This keeps the cash flow steady in real terms, and avoids the real purchasing power erosion of nominal bonds.

Collateral

Collateral or Asset Backed Bonds are guaranteed by specific assets in the case that a default occurs. These bonds guarantee you will be reimbursed for the par value of the bond with the specific collateral mentioned in the bond’s contract. Even if the firm defaults, you are promised to receive the collateral or its sales value. Be certain the value of the collateral is worth the risk of the issuer defaulting, or that the asset backing the issue is stable.

Ensuring the asset backing the bond is stable is required, since collateral bonds can have many differing asset types backing them which can easily change in value. Certain bonds are backed by other financial securities and assets. The stability of the collateral depends on the performance of these securities and assets in the marketplace. Mortgage based bonds are backed by lenders paying housing loans. During economic disasters resulting in high unemployment, mortgage payments may slow while foreclosures rise. Mortgage backed bonds will become susceptible to default. Other bonds are backed by the equipment that they are issued to purchase. Bonds which are not backed by any collateral are known as unsecured bonds.  

Structured

Structured Securities have attached options for varying functions. These securities can have simple options, such as calls or puts, or far more complex option structures. They can have highly variable or conditional interest rates. Each complication increases the difficulty to determine accurate pricing of the structured security. The value of the bond depends on the options attached.

Complexity in investments usually does not benefit you. You should make sure you completely understand the investment before purchase. If you cannot understand the investment, you either do not know enough to own it and should learn more or you are being intentionally manipulated for profit via complications. Neither of these two options usually results in substantial profit for an investor.

 Catastrophe & Death

Certain Bonds have payments which continue only if certain events do not happen. Two examples of this are Catastrophe bonds and Death Bonds. Both of these bonds pay if a non-tragic event happens. If it does not flood, if there is not a hurricane, tornado, earthquake, or a death of a specific person or rate of people, these bonds will continue their payments. If they occur, the interest paid and the par value will be either reduced or canceled. Catastrophe bonds cancel in case of disasters and Death bonds cancel in case of specific death or life insurance claim ratios. Both bond types are issued by insurers transferring insurance risks to you. It’s your loss if things go bad, and they simply pay the money you paid them to the insured.

Bond Risks

Bonds come attached to several different sets of risks. There are six specific major risks for bondholders. The first two are the major risks of bonds: Credit and Inflation risk. The risk of a firm defaulting, or failing to pay its interest or principal is known as the credit risk. The risk of bond returns being outpaced by inflation is known as inflation risk.

The next three bond risks all revolve around Central Banks and Interest rates. Interest Rate Risk is the risk that interest rates will be moved above your bond’s rates. Reinvestment Risk occurs when you are forced to invest at lower interest rates than you were previously receiving after maturity. Call Risk occurs when the interest rates are moved below your bond’s interest rate and your bond is called by the issuer to save money. Call Risk can occur for other reasons as well.

Lastly, the risk of a firm having its credit rating lowered, is known as Downgrade Risk. This results in a number of side headaches for investors, including loss of price value, difficulty selling, and lopsided risk return relationships.

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