Types of Bonds

Learning Outcomes

  • 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.

The words "coupon code" on the screen of a smartphone.Coupon: The rate of interest paid on the bond. Bonds used to be printed on paper and the holder would redeem a coupon in order to get paid.

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.

A collection of stock and bond bank notes.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.