- Describe various types of bonds
Debt financing has a language of its own, so before we delve into the types of bonds, let’s review some financial terms related to bonds.
Issuer: The entities that borrow money by issuing bonds which include the government, government agencies, municipal bodies, and corporations.
Face Value: The principal amount that is returned on maturity. As you will see, this is not always the amount of the proceeds that the issuer receives.
Rating: Every bond is usually rated by credit rating agencies. A higher credit rating usually results in a lower coupon rate.
Coupon payment frequency: The coupon (interest) payments on the bond usually have a payment frequency. The coupons are usually paid annually or semi-annually; however, they may be paid quarterly or monthly as well.
Yield: The effective return the investor makes on the bond is called the yield. If you buy a bond for $1000 with a 10% coupon that pays semi-annually, you get $50 every six months in interest and the yield is 10%. However, if market rates are different than the coupon rate, you may pay more or less than the face value of $1000 for the bond in order to get a yield that is the equivalent to the market rate. We’ll cover this later.
Different types of bonds: The simplest bond has a fixed interest rate and a defined maturity and is usually issued and redeemed at the face value. It is also known as a straight bond or a bullet bond or even a plain vanilla bond.
Zero coupon bonds: A zero coupon bond is a type of bond where there are no coupon payments made. It is not that there is no yield; the zero coupon bonds are issued at a price lower than the face value (say $950) and then pay the face value on maturity ($1000). The difference will be the yield for the investor.
Convertible bonds: Convertible bonds are a special variety of bonds that can be converted to equity shares at a specified time at a pre-set conversion price. These kinds of bonds are often used in start-up financing by investors who want the initial security of debt but who might later want to buy into the company as shareholders.
Callable bonds: Bonds that are issued with a specific feature where the issuer has the right to buy back the bonds at a pre-agreed price and a pre-fixed date are callable bonds. Since these bonds allow a benefit to the issuer to repay off the liability before maturity, these bonds usually offer a coupon rate higher than a normal straight coupon-bearing bond.
Puttable bonds: Bonds are issued with a specific feature where the bondholder has the right to sell back the bonds at a pre-fixed date before maturity are puttable bonds. Since these bonds allow a benefit to the bondholders to ask for the principal repayment before maturity, these bonds usually offer a coupon rate lower than a normal straight coupon-bearing bond.
Serial bonds: A serial bond is a bond issue structured so that a portion of the outstanding bonds mature at regular intervals until all of the bonds have matured. Because the bonds mature gradually over a period of years, these bonds are used to finance projects that provide a consistent income stream for bond repayment.
In addition, bonds, like notes payable, could be secured or unsecured, and there is a specific class of high-risk, high-yield bonds called junk bonds that are usually unsecured and likely to not be repaid, hence the high yield.