Bonds, in general, can be classified by issuer type, by type of market they trade in, and by type of coupon rate.
Although the term “bond” may be used to describe any debt security, irrespective of its maturity, debt securities can also be referred to by different names based on time to maturity at issuance. Debt securities with maturities of one year or less may be referred to as bills. Debt securities with maturities from 1 to 10 years may be referred to as notes. Debt securities with maturities longer than 10 years are referred to as bonds.
Issuer. Bonds issued by companies are referred to as corporate bonds and bonds issued by central governments are sovereign or government bonds. Local and regional government bodies may also issue bonds.
In some cases, bonds issued by certain central governments carry particular names in the market. For example, bonds issued by the US government are referred to as Treasury securities or Treasuries, by the New Zealand government as Kiwi Bonds, by the UK government as gilts, by the German government as Bunds, and by the French government as OATs (obligations assimilables du Trésor).
Market. At issuance, investors buy bonds directly from an issuer in the primary market. The primary market is the market in which new securities are issued and sold to investors. The bondholders may later sell their bonds to other investors in the secondary market. In the secondary market, investors trade with other investors. When investors buy bonds in the secondary market, they are entitled to receive the bonds’ remaining promised payments, including coupon payments until maturity and principal at maturity.
Coupon rates. Bonds are often categorized by their coupon rates: fixed-rate bonds, floating-rate bonds, and zero-coupon bonds. These categories of bonds are described further in the following sections.
4.1 Fixed-Rate Bonds
Fixed-rate bonds are the main type of debt securities issued by companies and governments. Because debt securities were historically issued with fixed coupon rates and paid fixed coupon payments, they may be referred to as fixed-income securities. A fixed-rate bond has a finite life that ends on the bond’s maturity date, offers a coupon rate that does not change over the life of the bond, and has a par value that does not change. If interest rates in the market change or the issuer’s creditworthiness changes over the life of the bond, the coupon the issuer is required to pay does not change. Fixed-rate bonds pay fixed periodic coupon payments during the life of the bond and a final par value payment at maturity.
Example 2 describes how Walt Disney Corporation raised capital in August 2011 by using three different fixed-rate bond issues. Notice how the bond issues with longer times to maturity have higher coupon rates.
EXAMPLE 2. FIXED-RATE BOND
On 16 August 2011, the Walt Disney Corporation, a US company, raised $1.85 billion in capital with three debt issues. It issued $750 million in 5-year fixed-rate bonds offering a coupon rate of 1.35%, $750 million in 10-year fixed-rate bonds offering a coupon rate of 2.75%, and $350 million in 30-year fixed-rate bonds offering a coupon rate of 4.375%. Coupon payments are due semiannually (twice per year) on 16 February and 16 August. The following table summarises features of these issues. On the maturity date, each bondholder will receive $1,000 per bond plus the final semiannual coupon payment.
4.2 Floating-Rate Bonds
Floating-rate bonds, sometimes referred to as variable-rate bonds or floaters, are essentially identical to fixed-rate bonds except that the coupon rate on floating-rate bonds changes over time. The coupon rate of a floating-rate bond is usually linked to a reference rate. The London Interbank Offered Rate (Libor) is a widely used reference rate.
The calculation of the floating rate reflects the reference rate and the riskiness (or creditworthiness) of the issuer at the time of issue. The floating rate is equal to the reference rate plus a percentage that depends on the borrower’s (issuer’s) creditworthiness and the bond’s features. The percentage paid above the reference rate is called the spread and usually remains constant over the life of the bond. In other words, for an existing issue, the spread used to calculate the coupon payment does not change to reflect any change in creditworthiness that occurs after issue. But the reference rate does change over time with changes in the level of interest rates in the economy.
Floating rate = Reference rate + Spread
In bond markets, the practice is to refer to percentages in terms of basis points. One hundred basis points (or bps, pronounced bips) equal 1.0%, and one basis point is equal to 0.01%, or 0.0001. Therefore, rather than stating a floating rate as Libor plus 0.75%, the floating rate would be stated as Libor plus 75 bps. A floating-rate bond’s coupon rate will change, or reset, at each payment date, typically every quarter. Floating-rate coupon payments are paid in arrears—that is, at the end of the period on the basis of the level of the reference rate set at the beginning of the period. On a payment date, the coupon rate is set for the next period to reflect the current level of the reference rate plus the stated spread. This new coupon rate will determine the amount of the payment at the next payment date. Example 3 is a hypothetical example illustrating the effect of changes in a reference rate on coupon rates and coupon payments.
EXAMPLE 3. FLOATING-RATE BOND
On 31 March, a UK company raises £2 million by issuing floating-rate notes with a maturity of nine months. The coupon rate is three-month Libor plus 140 bps (1.40%). Note that even though it is called three-month Libor, the rate quoted is an annual rate. It is standard practice to quote interest rates as an annual rate. Therefore, the total rate (Libor + 1.40%) must be divided by four to calculate the quarterly coupon payment. The coupon rate is reset every quarter. The following table shows the Libor rate at the beginning of each quarter and the total coupon payment made each quarter by the company.
4.2.1 Inflation-Linked Bonds
An inflation-linked bond is a particular type of floating-rate bond. Inflation-linked bonds contain a provision that adjusts the bond’s par value for inflation and thus protects the investor from inflation. Recall from the Macroeconomics chapter that inflation will typically reduce an investor’s purchasing power from bond cash flows. Changes to the par value reduce the effect of inflation on the investor’s purchasing power from bond cash flows. For most inflation-linked bonds, the par value—not the coupon rate—of the bond is adjusted at each payment date to reflect changes in inflation (which is usually measured via a consumer price index). The bond’s coupon payments are adjusted for inflation because the fixed coupon rate is multiplied by the inflation-adjusted par value. Examples of inflation-linked bonds are Treasury Inflation-Protected Securities (TIPS) in the United States, index-linked gilts in the United Kingdom, and iBonds in Hong Kong.
Because of the inflation protection offered by inflation-linked bonds, the coupon rate on an inflation-linked bond is lower than the coupon rate on a similar fixed-rate bond.
4.3 Zero-Coupon Bonds
As with fixed-rate and floating-rate bonds, zero-coupon bonds have a finite life that ends on the bond’s maturity date. Zero-coupon bonds do not, however, offer periodic interest payments during the life of the bond. The only cash flow offered by a zero coupon bond is a single payment equal to the bond’s par value that is paid on the bond’s maturity date.
Zero-coupon bonds are issued at a discount to the bond’s par value—that is, at an issue price that is lower than the par value. The difference between the issue price and the par value received at maturity represents the investment return earned by the bondholder over the life of the zero-coupon bond, and this return is received at maturity.
Many debt securities issued with maturities of one year or less are issued as zero coupon debt securities. For example, Treasury bills issued by the US government are issued as zero-coupon securities. Companies and governments sometimes issue zero-coupon bonds that have maturities of longer than one year. Because of the risk involved when the only payment is the payment at maturity, investors are reluctant to buy zero-coupon bonds with long terms to maturity. If they are willing to do so, the expected return has to be relatively high compared to the interest rate on coupon paying bonds, and many issuers are reluctant to pay such a high cost for borrowing. Also, if the buyer of a zero-coupon bond decides to sell it prior to maturity, its price could be very different because of changes in interest rates in the market and/or changes in the issuer’s creditworthiness.
Example 4 describes the issue of zero-coupon notes by Vodafone on 1 December 2008. Although this issue has a 20-year term to maturity, it is termed a notes issue.
EXAMPLE 4. ZERO-COUPON BOND
On 1 December 2008, Vodafone Group, a UK company, issued zero-coupon notes with a par value of €186.35 million to mature on 1 December 2028. The notes were issued (sold) for 26.83% of par value. In other words, for every €1,000 of par value, investors paid €268.31.
1 . If an investor bought the note on 1 December 2008, holds it to maturity, and receives €1,000, the annual return over the life of the bond to the investor is 6.80%. The investor will receive no cash flows before 1 December 2028 unless he or she sells the note. The annual return of 6.80% represents the investor’s required rate of return.
2 . To illustrate the sensitivity of zero-coupon bonds to changes in required rate of return, assume that an original buyer decides to sell the Vodafone note one year after issue. Furthermore, assume that at that time, given market conditions and the creditworthiness of Vodafone, the required rate of return on the note is 8.0%. Under these circumstances, the original buyer would receive €231.71 for every €1,000 of par value.
