Before investing in bonds, you should know the different types of bonds that the market has. Below you will see the top 5 types of bonds that you should know about.
What is a Bond?
A bond is a fixed income investment wherein an investor loans money to an entity. It borrows the funds for a distinct period at a fixed interest rate.
Companies, municipalities, and sovereign governments to boost money and finance a variety of projects and activities use bonds.
Meanwhile, the owners of bonds are the debt-holders or the creditors of the issuer.
It is also commonly known as fixed-income securities and are one of the three main generic asset classes. There are some corporate and government bonds that are publicly traded on exchanges, while some are traded only over-the-counter.
Bonds, on the other hand, works when a company needs to boost money to finance new projects, maintain ongoing operations, or refinance existing debts. A company may issue bonds directly to investors instead of obtaining loans from a bank.
The indebted entity will issue a bond that contractually states the interest rate will be paid and the time when the loaned funds need to be returned. The interest rate is the return that bondholders earn for loaning their funds to the issuer.
Moreover, the issuance price of a bond is usually ranges from $100 to $1,000 face value per individual bond. The actual market price of a bond, however, depends on the number of factors such as the credit quality of the issuer, the length of time until expiration, and the coupon rate compared to the general interest rate environment at the time.
Types of Bonds
As an investor, you should know the different types of bonds that we have out there. So you will not be confused once you enter the market.
Here are some of the types of bonds that are used in the field:
Type #1: Convertible Bonds
Convertible bond might be used for a predetermined amount of equity of the company at certain period during its life. This is usually at the decision of the bondholder.
Convertibles, on the other hand, are also called as “CVs.”
Issuing a convertible bond is a way for one company to minimize a negative interpretation of an investor to its corporate actions.
A good example is if a public company chooses to issue a stock, the market usually interprets it as a sign that the share price of the company is overvalued. Meanwhile, to avoid this negative impression, a company may choose to issue a convertible bonds, in which a beholder would convert it to equity should the company continuously to do well.
However, from a perspective of an investor, convertible bond has a value-added component built into it. It is basically a bond with a stock option concealed inside. Although, it tends to offer a much lower rate of return as an exchange for the value of the option to trade the bond into stock.
Type #2: Term Bonds
A term bond is a bond that is from the same issue which share the same maturity dates. It has a call feature that can be used at a much earlier date that the other issued bonds.
A call feature, or also known as call provision, is a deal that a bond issuer and a buyer make. This deal is called “indenture,” which is the schedule and the price of redemptions and the maturity dates.
An example of term bonds are the corporate and municipal bonds that have 10-year call features. This only mean that the issuer can use it at a predetermined price at specific times before the bond matures.
Meanwhile, a term bond is the opposite of serial bond, which has many maturity schedules at regular intervals until the issue ends.
Type #3: Corporate Bonds
A corporate bond id issued by different kinds of companies. They are known as riskier than government-backed bonds. This is why they offer a much higher rate of return.
Companies can issue bonds just as it can issue stock. Meanwhile, larger corporations have a lot of flexibility when it comes to how much debt they can issue.
Basically, a short-term corporate bond has a maturity of less than five years, while intermediate is five to 12 years. The long term, on the other hand, is more than 12 years.
This type of bond is characterized by higher yields due to higher risk of a company defaulting than a government. The upside of corporate bonds is that it can be the most rewarding fixed-income investments.
Corporate bonds are sold by the representative bank.
Meanwhile, there are three kinds of corporate bonds. These are:
1. Preferred Stocks
These are technically stocks however they act like A-bonds. Just like bond payments, they will pay you fixed dividend at regular intervals.
They are little safer than stocks since holders get paid after a bondholder but before a common stockholder.
2. Certificates of Deposit
These are just like bonds that were issued by the bank. You will essentially loan the bank your money for a certain time for a guaranteed fixed rate of return.
3. Junk Bonds
Junk bonds or also known as high yield bonds are corporate bonds coming from companies that have a huge change of defaulting.
They will provide a higher interest rate to reimburse for the risk.
Type #4: Callable Bonds
This type of bond is also called “redeemable bonds,” can be redeemed by the issuer prior to maturity.
A premium is usually paid to the bond owner when the bond is called. The main cause of a call is a decline in interest rate.
If an interest rate has declined because a company first issued the bonds, it will likely want to refinance this debt as t much lower rate. In this case, in order for the company to save money it will call its current bonds and reissue new lower-interest bonds.
Type #5: Adjustment Bonds
A company issues an adjustment bond during a restructuring phase. This bond is given to the bondholders of an outstanding bond issue prior to the restructuring.
The debt obligation is consolidate and transferred from the outstanding bond issue to the adjustment bond. This process is effectively a recapitalization of the company’s outstanding debt obligations. This is accomplished through adjusting the terms like interest rates and lengths to maturity, to boost the likelihood that the corporation will be able to meet its obligations.
Meanwhile, if the corporation is near bankruptcy and it requires protection from creditors, it will be unable to make payments on its debt obligations. In this case, the company will be liquidated, while the value of the company will be spread among its creditors. However, creditors will only receive a fraction of their loans to the company.
The company and the creditors will be working together to recapitalize debt obligations so that the corporation will be able to meet its obligations and to continue its operations.
Characteristics of Bonds
As an investor, you must know that most bonds have some common basic characteristics that you should know about.
1. Coupon Rate
This is the rate of interest the bond issuer will be paying on the face value of the bond. This is expressed as a percentage. A good example of a coupon rate is a 5 percent coupon rate means that the bondholders will get 5% x $1000 face value, which equals to $50 every year.
2. Maturity Date
Maturity date is the date on which the bond will mature. It is also the date the bond issuer will be paying the bondholder the face value of the bond.
3. Face Value
Face value is the amount of money that the bond will be worth at its maturity. This will also be the reference amount that the bond issuer will use in calculating interest payments.
Example of face value, if an investor buys a bond at a premium $1,090 and another bought the same bond a t a discounted price of $980. When both bonds mature, both of the investors will be receiving the $1000 face value of the bond.
4. Issue Price
Issue price is the price in which the bond issuer originally sells the bonds.
5. Coupon Dates
Lastly, the coupon dates are the dates which the bond issuer will make an interest payment. Typicaly intervals are annual or semi-annual coupon payments.
Moreover, there two features of bonds, duration and credit quality, which are principal determinants of a bond’s interest rate. However, if the issuer has a poor credit rating, the risk of default is much greater and these bonds will tend to trade a discount.
In addition, bonds with a high default risk have higher interest rates than other bonds.
Bonds are fixed income investment wherein an investor loans money to an entity. These types of bonds will help you understand more about bond. And also to know what are the different kinds of bonds the market has.
Before you enter any market, it is important for you to have knowledge about the specific investment you are trying to enter. Take time to do your own research.
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