Classification of bonds

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Bonds can be classified based on the following

Issuer
Coupon Rate
Term to Maturity

Based on the type of issuer bonds can be classified as

Government bonds
Municipal bonds
Corporate bonds

Please visit "Bond Market/Fixed Income Market Basics" post for the detailed discussion of issuer based bonds.

Based on the coupon payment mode bonds can be classified as

Fixed coupon
Floating coupon
Inverse floater
Zero coupon

Fixed Coupon bonds

Usually these bonds are long term in nature. The interest rate and hence the amount of coupon is fixed irrespective of market conditions and the benchmark rate. The coupon is payable at specified time intervals before bond maturity, usually semi annually.

Floating coupon

The interest rate is reset periodically on the coupon reset date, in advance of the period to which it applies, based on some widely used benchmark rates LIBOR, treasury index rate.
The general formula isreference rate/benchmark rate + quoted margin.

Inverse Floater

These bonds pay a variable coupon that changes in direction opposite to the benchmark rate. An inverse floater subtracts the reference rate from the set coupon rate.
The general formula isInterest rate - reference rate/benchmark rate

Zero coupon bonds

Zero coupon bonds do not pay intermittent coupons. The accumulated coupons are paid at the end of the maturity along with the principal. They are issued at a deep discount as the face value which is paid out at the end of maturity contains principal as well as interest. The difference between the face value (the amount received at the end of maturity, in this case) and the issue price represents the coupon for zero coupon bonds.

Based on the term to Maturity bonds can be classified as

Callable bonds
Puttable bonds
Convertible bonds

Callable bonds

A bond which gives the issuer right to call back (redeem) a bond prior to its maturity under certain conditions. These conditions and the price of redemption are predetermined. Usually the redemption value is slightly more than the par value. The earlier the bond is called the higher is the redemption value. A company calls a bond if the interest rate of the issued bond is high compared to the market rate on similar instruments. It can reissue bonds at lower coupon rates by calling back the high interest rate bonds. Usually callable bonds carry call protection i.e. there is some period of time after issuance of bonds during which the issuer can’t call them.

Puttable bonds

Investors can sell the bond back to the issuer, prior to maturity, at a price decided when the bond is issued. If the market interest rate is higher than the coupon rate of the bond then the investors can exercise the right of put and purchase another bond from the market.

Differences between Callable and Puttable bonds

A call option is positive for the issuer where as a put option is good for the investors.Callable bonds are issued at discount prices compared to puttable bonds for the same profile. In the case of a callable bond, the individual with a long position in this security will essentially long the bond and short the embedded call option. In a puttable bond, the individual with a long position in this security will essentially long the bond and long the embedded put option.

Convertible bond

A convertible bond gives the holder of the bond to convert the debt securities to common shares of the issuer. The equity shares are allocated based on a convertible ratio.

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May 27, 2008 | Filed Under Bonds 

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