- Classification on the basis of Variability of Coupon
- Zero Coupon Bonds
Zero Coupon Bonds are issued at a discount
to their face value and at the time of maturity, the
principal/face value is repaid to the holders. No interest
(coupon) is paid to the holders and hence, there are no cash
inflows in zero coupon bonds. The difference between issue price
(discounted price) and redeemable price (face value) itself acts
as interest to holders. The issue price of Zero Coupon Bonds is
inversely related to their maturity period, i.e. longer the
maturity period lesser would be the issue price and vice-versa.
These types of bonds are also known as Deep Discount Bonds.
- Treasury Strips
Treasury strips are more popular in the
United States and not yet available in India. Also known as
Separate Trading of Registered Interest and Principal
Securities, government dealer firms in the United States buy
coupon paying treasury bonds and use these cash flows to further
create zero coupon bonds. Dealer firms then sell these zero
coupon bonds, each one having a different maturity period, in
the secondary market.
- Floating Rate Bonds
In some bonds, fixed coupon rate to be
provided to the holders is not specified. Instead, the coupon
rate keeps fluctuating from time to time, with reference to a
benchmark rate. Such types of bonds are referred to as Floating
Rate Bonds.
For better understanding let us consider an example of one such
bond from IDBI in 1997. The maturity period of this floating
rate bond from IDBI was 5 years. The coupon for this bond used
to be reset half-yearly on a 50 basis point mark-up, with
reference to the 10 year yield on Central Government securities
(as the benchmark). This means that if the benchmark rate was
set at “X” %, then coupon for IDBI’s floating
rate bond was set at “(X + 0.50)” %.
Coupon rate in some of these bonds also have floors and
caps. For example, this feature was present in the same case of
IDBI’s floating rate bond wherein there was a floor of
13.50% (which ensured that bond holders received a minimum of
13.50% irrespective of the benchmark rate). On the other hand, a
cap (or a ceiling) feature signifies the maximum coupon that the
bonds issuer will pay (irrespective of the benchmark rate).
These bonds are also known as Range Notes.
More frequently used in the housing loan markets where coupon
rates are reset at longer time intervals (after one year or
more), these are well known as Variable Rate Bonds and
Adjustable Rate Bonds. Coupon rates of some bonds may even move
in an opposite direction to benchmark rates. These bonds are
known as Inverse Floaters and are common in developed markets.
- Classification on the Basis of Variability of Maturity
- Callable Bonds
The issuer of a callable bond has the
right (but not the obligation) to change the tenor of a bond
(call option). The issuer may redeem a bond fully or partly
before the actual maturity date. These options are present in
the bond from the time of original bond issue and are known as
embedded options.
A call option is either a European option or an American
option. Under an European option, the issuer can exercise the
call option on a bond only on the specified date, whereas under
an American option, option can be exercised anytime before the
specified date.
This embedded option helps issuer to reduce the costs when
interest rates are falling, and when the interest rates are
rising it is helpful for the holders.
- Puttable Bonds
The holder of a puttable bond has the
right (but not an obligation) to seek redemption (sell) from the
issuer at any time before the maturity date. The holder may
exercise put option in part or in full. In riding interest rate
scenario, the bond holder may sell a bond with low coupon rate
and switch over to a bond that offers higher coupon rate.
Consequently, the issuer will have to resell these bonds at
lower prices to investors. Therefore, an increase in the
interest rates poses additional risk to the issuer of bonds with
put option (which are redeemed at par) as he will have to lower
the re-issue price of the bond to attract investors.
- Convertible Bonds
The holder of a convertible bond has the
option to convert the bond into equity (in the same value as of
the bond) of the issuing firm (borrowing firm) on pre-specified
terms. This results in an automatic redemption of the bond
before the maturity date. The conversion ratio (number of equity
of shares in lieu of a convertible bond) and the conversion
price (determined at the time of conversion) are pre-specified
at the time of bonds issue. Convertible bonds may be fully or
partly convertible. For the part of the convertible bond which
is redeemed, the investor receives equity shares and the
non-converted part remains as a bond.
- Classification on the basis of Principal Repayment
- Amortising Bonds
Amortising Bonds are those types of bonds
in which the borrower (issuer) repays the principal along with
the coupon over the life of the bond. The amortising schedule
(repayment of principal) is prepared in such a manner that whole
of the principle is repaid by the maturity date of the bond and
the last payment is done on the maturity date. For example -
auto loans, home loans, consumer loans, etc.
- Bonds with Sinking Fund Provisions
Bonds with Sinking Fund Provisions have a provision as per
which the issuer is required to retire some amount of
outstanding bonds every year. The issuer has following options
for doing so:
- By buying from the market
- By creating a separate fund which calls the bonds on
behalf of the issuer
Since the outstanding bonds in the market are continuously
retired by the issuer every year by creating a separate fund
(more commonly used option), these types of bonds are named as
bonds with sinking fund provisions. These bonds also allow the
borrowers to repay the principal over the bond’s life.
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