Types of Bonds and Their Characteristics

Bonds are the types of financial instruments that have low risk. Due to this low risk nature, these fixed income financial instruments are preferred by many investors. There are several types of bonds that can be chosen based on their time and amount of yield. By choosing an appropriate bond type, you can increase the returns on investment without facing too much risk.

Table of Contents

• What are Bonds?
• Types of Bonds
• Treasury Bonds
• High-yield Bonds
• Inflation-Protected Bonds
• Municipal Bonds
• Corporate Bonds
• Floating Rate Bonds
• Zero-Coupon Bonds
• Convertible Bonds
• Callable Bonds
• Characteristics of Bonds

What are Bonds?

Bonds are fixed-income financial instruments in which people invest as they offer regular income and diversification benefits. A bond is a loan given by an investor to the borrower. It is an I.O.U. (I owe you) between lender and borrower.  The bond includes details of loan and its payment details. Different companies and governments issue bonds for financing projects. Those who issue bonds are known as issuers and those who own bonds are known as debtholders or creditors. Bonds are traded in the stock market so it is important to understand the criticalities of the stock market. There are several online stock market courses through which you learn about the details of financial market.

Types of Bonds

There are mainly the following ten types of bonds:

1. Treasury Bonds
2. High-yield Bonds
3. Inflation-Protected Bonds
4. Municipal Bonds
5. Corporate Bonds
6. Floating Rate Bonds
7. Zero-Coupon Bonds
8. Convertible Bonds
9. Callable Bonds

1. Treasury Bonds

Treasury bonds or T-bonds are type of government debt securities that are issued by the US government. The creditor will earn a semi-annual interest till its maturity with these types of bonds. These types of bonds have long duration as they are issued with two maturity periods of 20 and 30 years. Through treasury bonds, the US government can raise taxes and thus, increase its revenue to ensure complete payment.

The bond is available only in electronic form. Bond rate is fixed at the auction and this rate does not vary till its maturity rate. The minimum possible rate is 0.125%. The latest 20-year bond issued on 4th April 2024 is issued at a 4.5% bond rate. The 30-year bond is issued at a bond rate of 4.250%. 

Every year 4 original issues of bond occurs at bond auction. Every year, the bond auction takes place for 8 reopenings. In case the bid is non-competitive, then the maximum purchase amount is set at $5 million. If the bid is competitive, then, the maximum purchase price is 35% of the offering.

2. High-Yield Bonds

These bonds are also known as junk bonds. They pay higher rate of interest since they have lower credit ratings as compared to investment-grade bonds. These types of bonds have a higher probability of defaulting due to which they pay higher yields as compared to investment-grade bonds for compensating investors. 

Capital-intensive firms or startup companies issue high-yield debt bond types. This corporate bond represents the debt issued by a firm with a promise of paying interest and returning the principal at the time of maturity. These types of bonds are further subcategorized into:

• Fallen Angels: These bonds have lost their good credit rating due to which they are downgraded by a major rating agency.
• Rising stars: This is a bond with an improved rating due to the issuing company's improving credit quality. This type of bond slowly heads towards becoming an investment-quality bond.
  

3. Inflation-index-linked Bonds

These bond types are used for hedging against inflation risk since their value increase during the inflationary period. Such bonds reduce uncertainty due to which they are a popular long-range planning investment method. These bonds are linked to the cost of consumer goods as measured by the inflation index. Each country has its own agency responsible for issuing inflation-linked bonds. The outstanding principle for inflation-linked bonds increases with inflation and so does, the face or par value of the bond. 

4. Municipal Bonds

Municipal bonds are the type of debt security that are issued by governing bodies. These are issued to raise money to pay for capital expenditure. Bondholders become the creditors with the promise to get interest on their principal balance. These types of bonds are exempted from most taxes due to which people in higher income tax brackets invest in them. 

Two main municipal bond types are general obligation and revenue bonds. The general obligation bond type is issued by government bodies and is not supported by revenue generated by any project. Some general obligation bonds are backed by property taxes and some of these bonds are payable from general obligation bonds. Revenue bond types secure both principal and interest amounts through sales, issuers and taxes. In case a municipality issues a bond, a third party covers interest and principal payments.

5. Corporate Bonds

Corporate bonds are issued by companies. These companies give a legal commitment to pay a pre-established number of interest payments on the principal amount at maturity. When investor buys a corporate bond, he/she does not own any equity in the company. Only the principal amount is returned to the investor since interest has been paid. 

There is no obligation to pay dividends to the shareholders. However, in case of bankruptcy, bond investors are given priority over shareholders. Through corporate bonds, companies raise money to finance their operations, asset purchase and pay their shareholders and creditors. High-quality corporate bond types are safer investment options.

6. Floating Rate Bonds

Floating rate bonds are issued by the government where it pays periodic interest to investors. After a period, the government re-fixes the interest rate. There are mainly two types of bonds here. One is callable floating rate bonds and the other one is non-callable floating rate bonds. 

• Callable floating rate bonds: These bond types allow bond issuers to call back floating rate bonds. Once the bond issuer repays the initial principal amount, the bondholder will stop getting interest. Through callable floating rate bonds, the issuer is protected against the change in interest rates and can also retire the bond before maturity.
• Non-callable floating rate bonds: There is no option to call back the bond or retire it before maturity. Issuers must pay the interest rate which is derived from the benchmark even if they incur losses after paying interest. 

In India, the interest rate is re-fixed every 6 months. At present, the interest rate for floating-rate bonds is set at 7.15%. 

7. Zero-Coupon Bonds

Also known as accrual bonds, these financial instruments do not pay interest. Rather these bonds trade at deep discounts. In simple terms, these are sold at lower prices than their face value and pay the investor the full face value during maturity. Due to this, investors can gain maturity if the bond is redeemed for full face value. Some bonds are zero-coupon bonds from the start. Since the beginning, they are meant to be sold at discount prices and do not pay any interest until they reach their due date. After the due date, they pay full face value. Some bond types get converted when financial institutions remove the interest payment clause from normal bonds and repackage them as zero-coupon bonds.

8. Convertible Bond

Convertible bond is a type of bond that gives a right or obligation to an investor to exchange the bond for predetermined number of shares in the issuing company. This happens at certain times during the lifetime of a bond. This debt security shows the features of both equity and debt. In case, the investor does not convert the bond into equity, he/she will receive the face value of the bond during maturity. In case the investor converts the bond into equity or shares, bond will only possess the features of equity.

Mostly those companies that have a lower credit rating and high growth potential issue these types of bonds. Through convertible bonds, stock price undergoes future capital appreciation. While these bonds are not classified formally, there are three types of convertible bonds: vanilla convertible bonds, mandatory convertibles and reverse convertibles. Here is the lifecycle of this bond:

9. Callable Bonds

Also known as redeemable bonds, these bond types can be redeemed by issuer before the maturity date of the bond. When the issuer calls the bond, investor will get the call price along with the accrued interest to date.  In most cases, a callable bond's call price is equal to the face value of the bond.

Once the bond is called and payment including call price and accrued interest is done, further payments are stopped. In some cases call premium is also paid. The call premium refers to the dollar amount over par value of callable debt security. 

Characteristics of Different Types of Bonds

The following points highlight the characteristics of bonds:

• Bonds are based on a legal document called indenture that outlines their characteristics. 
• For some bonds such as corporate bonds, the ROI is based on the creditworthiness of the company issuing them. 
• Bonds are a safer source of investment compared to other sources of investment. 
• However, they are still prone to certain types of risks including interest rate risk, prepayment risk and default risk.
• Most bonds come with a rating to indicate their quality of credit. This rating shows the bond's ability to pay principal as well as interest.
• Bond yields provide the measure of return on bonds.

It is important to learn about bonds since they help in preserving your capital. Along with that, they help in earning risk-free returns. Those who want to get into the field of Finance must learn about these negotiable financial instrument types since it will help them in financial management. Here are some courses that can help you learn about bonds in further details:

• Bonds and Fixed Income Mathematics
• Advanced Understanding of Stocks and Bonds 
• Stocks and Bonds 
• Crash Course in Bonds