Bonds

Different types of bonds

Bonds

The bond market is by far the largest securities market in the world, providing investors with virtually limitless investment options. Many investors are familiar with aspects of the market, but as the number of new products grows, even a bond expert is challenged to keep pace. Once viewed as a means of earning interest while preserving capital, bonds have evolved into a Rs100 trillion global marketplace that can offer many potential benefits to investment portfolios, including attractive returns.

What makes a bond a bond?

A bond is a loan that the bond purchaser, or bondholder, makes to the bond issuer. Governments, corporations and municipalities issue bonds when they need capital. An investor who buys a government bond is lending the government money. If an investor buys a corporate bond, the investor is lending the corporation money. Like a loan, a bond pays interest periodically and repays the principal at a stated time, known as maturity.

Suppose a corporation wants to build a new manufacturing plant for Rs1 million and decides to issue a bond offering to help pay for the plant. The corporation might decide to sell 1,000 bonds to investors for Rs1,000 each. In this case, the “face value” of each bond is Rs1,000. The corporation – now referred to as the bond issuer − determines an annual interest rate, known as the coupon, and a time frame within which it will repay the principal, or the Rs1 million. To set the coupon, the issuer takes into account the prevailing interest rate environment to ensure that the coupon is competitive with those on comparable bonds and attractive to investors. The issuer may decide to sell five-year bonds with an annual coupon of 5%. At the end of five years, the bond reaches maturity and the corporation repays the Rs1,000 face value to each bond holder.How long it takes for a bond to reach maturity can play an important role in the amount of risk as well as the potential return an investor can expect. A Rs1 million bond repaid in five years is typically regarded as less risky than the same bond repaid over 30 years because many more factors can have a negative impact on the issuer’s ability to pay bondholders over a 30-year period relative to a 5-year period. The additional risk incurred by a longer-maturity bond has a direct relation to the interest rate, or coupon, the issuer must pay on the bond. In other words, an issuer will pay a higher interest rate for a long-term bond. An investor therefore will potentially earn greater returns on longer-term bonds, but in exchange for that return, the investor incurs additional risk.

Every bond also carries some risk that the issuer will “default,” or fail to fully repay the loan. Independent credit rating services assess the default risk, or credit risk, of bond issuers and publish credit ratings that not only help investors evaluate risk, but also help determine the interest rates on individual bonds. An issuer with a high credit rating will pay a lower interest rate than one with a low credit rating. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer.

What determines the price of a bond in the open market?

Bonds can be bought and sold in the “secondary market” after they are issued. While some bonds are traded publicly through exchanges, most trade over-the-counter between large broker-dealers acting on their clients’ or their own behalf.

A bond’s price and yield determine its value in the secondary market. Obviously, a bond must have a price at which it can be bought and sold (see “Understanding bond market prices” below for more), and a bond’s yield is the actual annual return an investor can expect if the bond is held to maturity. Yield is therefore based on the purchase price of the bond as well as the coupon.

A bond’s price always moves in the opposite direction of its yield, as previously illustrated. The key to understanding this critical feature of the bond market is to recognize that a bond’s price reflects the value of the income that it provides through its regular coupon interest payments. When prevailing interest rates fall – notably, rates on government bonds – older bonds of all types become more valuable because they were sold in a higher interest rate environment and therefore have higher coupons. Investors holding older bonds can charge a “premium” to sell them in the secondary market. On the other hand, if interest rates rise, older bonds may become less valuable because their coupons are relatively low, and older bonds therefore trade at a “discount.”

Understanding bond market prices

In the market, bond prices are quoted as a percent of the bond’s face value. The easiest way to understand bond prices is to add a zero to the price quoted in the market. For example, if a bond is quoted at 99 in the market, the price is Rs990 for every Rs1,000 of face value and the bond is said to be trading at a discount. If the bond is trading at 101, it costs Rs1,010 for every Rs1,000 of face value and the bond is said to be trading at a premium. If the bond is trading at 100, it costs Rs1,000 for every Rs1,000 of face value and is said to be trading at par. Another common term is “par value,” which is simply another way of saying face value. Most bonds are issued slightly below par and can then trade in the secondary market above or below par, depending on interest rate, credit or other factors.

Put simply, when interest rates are rising, new bonds will pay investors higher interest rates than old ones, so old bonds tend to drop in price. Falling interest rates, however, mean that older bonds are paying higher interest rates than new bonds, and therefore, older bonds tend to sell at premiums in the market.

On a short-term basis, falling interest rates can boost the value of bonds in a portfolio and rising rates may hurt their value. However, over the long term, rising interest rates can actually increase a bond portfolio’s return as the money from maturing bonds is reinvested in bonds with higher yields. Conversely, in a falling interest rate environment, money from maturing bonds may need to be reinvested in new bonds that pay lower rates, potentially lowering longer-term returns.

Measuring bond risk: what is duration?

The inverse relationship between price and yield is crucial to understanding value in bonds. Another key is knowing how much a bond’s price will move when interest rates change.

To estimate how sensitive a particular bond’s price is to interest rate movements, the bond market uses a measure known as duration. Duration is a weighted average of the present value of a bond’s cash flows, which include a series of regular coupon payments followed by a much larger payment at the end when the bond matures and the face value is repaid, as illustrated below.

Duration, like the maturity of the bond, is expressed in years, but as the illustration shows, it is typically less than the maturity. Duration will be affected by the size of the regular coupon payments and the bond’s face value. For a zero-coupon bond, maturity and duration are equal since there are no regular coupon payments and all cash flows occur at maturity. Because of this feature, zero-coupon bonds tend to provide the most price movement for a given change in interest rates, which can make zero-coupon bonds attractive to investors expecting a decline in rates.

 The end result of the duration calculation, which is unique to each bond, is a risk measure that allows investors to compare bonds with different maturities, coupons and face values on an apples-to-apples basis. Duration provides the approximate change in price that any given bond will experience in the event of a 100-basis-point (one percentage point) change in interest rates. For example, suppose that interest rates fall by 1%, causing yields on every bond in the market to fall by the same amount. In that event, the price of a bond with a duration of two years will rise 2% and the price of a five-year-duration bond will rise 5%.

The weighted average duration can also be calculated for an entire bond portfolio, based on the durations of the individual bonds in the portfolio.

The role of bonds in a portfolio

Since governments began to issue bonds more frequently in the early twentieth century and gave rise to the modern bond market, investors have purchased bonds for several reasons: capital preservation, income, diversification and as a potential hedge against economic weakness or deflation. When the bond market became larger and more diverse in the 1970s and 1980s, bonds began to undergo greater and more frequent price changes and many investors began to trade bonds, taking advantage of another potential benefit: price, or capital, appreciation. Today, investors may choose to buy bonds for any or all of these reasons.

Capital preservation: Unlike equities, bonds should repay principal at a specified date, or maturity. This makes bonds appealing to investors who do not want to risk losing capital and to those who must meet a liability at a particular time in the future. Bonds have the added benefit of offering interest at a set rate that is often higher than short-term savings rates.

Income: Most bonds provide the investor with “fixed” income. On a set schedule, whether quarterly, twice a year or annually, the bond issuer sends the bondholder an interest payment, which can be spent or reinvested in other bonds. Stocks can also provide income through dividend payments, but dividends tend to be smaller than bond coupon payments, and companies make dividend payments at their discretion, while bond issuers are obligated to make coupon payments.

Capital appreciation: Bond prices can rise for several reasons, including a drop in interest rates and an improvement in the credit standing of the issuer. If a bond is held to maturity, any price gains over the life of the bond are not realized; instead, the bond’s price typically reverts to par (100) as it nears maturity and repayment of the principal. However, by selling bonds after they have risen in price – and before maturity – investors can realize price appreciation, also known as capital appreciation, on bonds. Capturing the capital appreciation on bonds increases their total return, which is the combination of income and capital appreciation. Investing for total return has become one of the most widely used bond strategies over the past 40 years. (For more, see “Bond investment strategies.”)

Diversification: Including bonds in an investment portfolio can help diversify the portfolio. Many investors diversify among a wide variety of assets, from equities and bonds to commodities and alternative investments, in an effort to reduce the risk of low, or even negative, returns on their portfolios.

Potential hedge against an economic slowdown or deflation: Bonds can help protect investors against an economic slowdown for several reasons. The price of a bond depends on how much investors value the income the bond provides. Most bonds pay a fixed income that doesn’t change. When the prices of goods and services are rising, an economic condition known as inflation, a bond’s fixed income becomes less attractive because that income buys fewer goods and services. Inflation usually coincides with faster economic growth, which increases demand for goods and services. On the other hand, slower economic growth usually leads to lower inflation, which makes bond income more attractive. An economic slowdown is also typically bad for corporate profits and stock returns, adding to the attractiveness of bond income as a source of return.

If the slowdown becomes bad enough that consumers stop buying things and prices in the economy begin to fall – a dire economic condition known as deflation – then bond income becomes even more attractive because bondholders can buy more goods and services (due to their deflated prices) with the same bond income. As demand for bonds increases, so do bond prices and bondholder returns.

DIFFERENT TYPES OF BONDS

·         PLAIN VANILLA BONDS - A plain vanilla bond is a bond without any unusual features; it is one of the simplest forms of bond with a fixed coupon 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.

·         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 950Rs) and then pay the face value on maturity (Rs1000). The difference will be the yield for the investor. These are also called as discount bonds or deep discount bonds if they are for longer tenor.

·         DEFERRED COUPON BONDS – This type of bond is a blend of a coupon-bearing bond and a zero coupon bond. These bonds do not pay any coupon in the initial years and thereafter pay a higher coupon to compensate for no coupon in the initial years. Such bonds are issued by corporates whose business model has a gestation period before the actual revenues start. Examples of a company which may issue such type of bonds include construction companies.

·         STEP-UP BONDS - These are bonds where the coupon usually steps up after a certain period. They may also be designed to step up not once but in a series too. Such bonds are usually issued by companies where revenues/ profits are expected to grow in a phased manner. These are also called as a dual coupon or multiple coupon bonds.

·         STEP DOWN BONDS - These are just the opposite of Step-Up Bonds. These are bonds where the coupon usually steps down after a certain period. They may also be designed to step down not once but in a series too. Such bonds are usually issued by companies where revenues/ profits are expected to decline in a phased manner; this may be due to wear and tear of the assets or machinery as in the case of leasing.

·         FLOATING RATE BONDS - Floating rate bonds are so called because they have a coupon which is not fixed but rather linked to a benchmark. For example, a company may issue a floating-rate bond as Treasury bond rate + 50 bps (100 bps = 1%), In such cases on every interest payment date, the payment will be made 0.50% more than the treasury bill rate prevailing on the fixing date.

·         INVERSE FLOATERS - These types of bonds are similar to the floating rate bond in that the coupon is not fixed and is linked to a benchmark; however, the differentiating thing is that the rate is inversely related to the benchmark. In simple words, if the benchmark rate goes up; the coupon rate comes down and vice versa.

·         PARTICIPATORY BONDS - A participatory bond is a bond whereby the issuer promises a fixed rate but the coupon cash flow may increase if the profit/ income levels of the company rise to a pre-specified level and may reduce when income falls below a pre-specified level; thereby the investor participates in the return enjoyed based on company revenues/ income.

·         INCOME BONDS - Income bonds are similar to participatory bonds however these type of bonds do not have a reduction in interest payments if income/ revenue reduces.

·         PAYMENT IN KIND BONDS  - These types of bonds pay interest/coupon, not in terms of cash payouts but in the form of additional bonds.

·         EXTENDABLE BONDS - Extendable bonds are bonds that allow the holder to enjoy the right to extend the maturity if required. The holder has an additional benefit in this case because if the rate of interest in the market reduces, the holder may choose to extend the tenor and enjoy the higher rate of interest in terms of coupon payment. For this benefit, the holder may enjoy the coupon rates that are usually lower than a plain vanilla bond.

·         EXTENDABLE RESET BONDS - These are types of bonds which allow the issuer and the bondholders to reset the coupon rate based on the then prevailing market scenario. This is not linked to any benchmark but on the basis of renegotiation between the issuer and the bondholders. This is usually the case where bond tenor is very long.

·         PERPETUAL BONDS - These types of bonds pay a coupon rate on the face value till the life of the company. Though Perpetuity means forever, bonds with maturity above 100 years are also considered to be perpetual bonds.

·         CONVERTIBLE BONDS - Convertible bonds are a special variety of bonds which have an inbuilt feature of being converted to equity shares at a specified time at a pre-set conversion price.

·         FOREIGN CURRENCY CONVERTIBLE BONDS - Foreign currency convertible bond is a special type of bond issued in the currency other than the home currency. In other words, companies issue foreign currency convertible bonds to raise money in foreign currency.

·         EXCHANGEABLE BONDS - These bonds are similar to the convertible bonds but differ in one aspect that they can be exchanged for equity shares but not of the issuer. These can be exchanged for equity shares of another company which the issuer may have stake holding.

·         CALLABLE BONDS - Bonds that are issued with a specific feature where the issuer has the right to call back the bonds at a pre-agreed price and a pre-fixed date are called as 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 that are issued with a specific feature where the bondholder has the right to return back the bonds at a pre-fixed date before maturity are called as 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.

·         TREASURY STRIPS - In the US, Government dealer firms usually break down a coupon-bearing bond into a series of zero coupon bonds by considering each cash flow as a separate bond. For example, a 5-year semi annual coupon-bearing bond can be split into 10 zero coupon bonds with coupon amount as face value and 1 zero coupon bond with principal amount as the face value. The bond stripping usually is done to increase liquidity and facilitate easy tradability.

·         YANKEE BONDS - A dollar-denominated bond issued in the US by an issuer who is outside the US is called as Yankee bond.

·         SAMURAI BONDS - A yen-denominated bond issued in Japan by an issuer who is outside Japan is called as Samurai bond.

·         Shogun Bonds: A non-Yen denominated bond issued in Japan by an issuer who is outside Japan is called as Shogun bond.