A Guide to the Different Types of Bonds
By The Forex Review - 17 / March / 22 459
Dominick Bell
Bonds are a fixed income product that provides a way to raise long-term funds for various bodies and institutions.
There are different types of bonds that we will discuss in this article, but basically all bonds work on the same principle.
What are bonds?
Bonds are a type of debt.
In other words, a bond is a debt IOU (I Owe You), which is actually a promise of payment made by the bond issuer to the bond holder in accordance with the terms of the Bond Instrument.
The issuer of the bonds takes over the debt, and the person who buys the debt is the bondholder who provides the funds. The bond issuer can then use these funds to fund any spending plan they wish.
In return, they pay a fixed interest rate on the debt at regular intervals. At the end of the term, the bonds are redeemed, at which point the issuer returns the original amount of the debt (principal).
The transaction in which new debt is issued to buyers is called the primary market, but this is only part of the entire bond market. The bond market also has a secondary market in which previously issued bonds are traded between buyers and sellers as debt securities.
The bond market is vast, far superior to the stock market in terms of value.
Governments are the largest issuers of bonds. Governments issue long-term government bonds to help fund the spending needed to support their countries.
Other large fixed income issuers are banks and corporations. We will discuss both government bonds and corporate bonds below.
Of course, bonds are not the only type of debt guarantee. But bonds tend to have longer maturities than other debt securities.
Before we look at some common types of bonds, let's first briefly summarize the key terms we use when talking about bonds:
Principal - The amount of debt that the issuer has assumed and on which they pay interest to the bondholder.
Maturity - The maturity determines when the principal is due to be repaid to the bondholder.
Coupon - the interest rate paid by the issuer to the bondholder.
Yield - determines the rate of return an investor will receive from a bond. This can be calculated in more than one way, but the simplest is the annual interest rate divided by the bond's prevailing market price. For example, the term government bond yield is known.
Current Market Price - Bonds will change in value over their life as they are traded on the secondary market.
There is a close relationship between interest rates and bonds. Because bonds pay a fixed amount periodically, they become more attractive when interest rates fall and less attractive when rates rise.
General types of bonds
In this section, we will discuss these types of bonds:
- Corporate bonds
- government bonds
- Municipal bonds
- Supranational bonds
- Types of bonds - Corporate bonds
Companies can raise funds in two main ways: floating shares or issuing debt in the form of corporate bonds.
There are many reasons why a corporation may want to raise money through such means, including M&A activities and fund expansion costs.
While a company can issue debt with a wide range of maturities, corporate bonds typically refer to corporate debt with a maturity of at least a year. Short-term debt is instead called corporate paper.
Government bonds and their types
Government bonds are a type of sovereign debt. Government bonds tend to have medium or long maturities, ranging from a couple of years to several decades.
This is in contrast to forms of short-term sovereign debt such as Treasury bills (GKOs).
Here is a list of some major government bonds:
- US T-bonds (also called long bonds, they have long maturities of 20 to 30 years);
- US T-notes (US medium-term debt with maturities from 2 to 10 years);
- UK Gilts (there are medium and long-term versions of gilding, like the UK government debt);
- German bond (long-term German debt with terms from 8.5 to 10.5 years);
- German schatz (also known as short package, German debt with maturities of around 2 years);
- German BOBL (Bundesobligationen, medium-term German debt with maturities of 4.5 to 5.5 years);
Italian government bonds (also known as BTP, Buoni del Tesoro Poliannuali, mid-term and long-term Italian treasury bonds with maturities ranging from 3 years to 30 years).
Although liquidity and risk depend on the government in question, government bonds are generally liquid and perceived as low risk, especially for countries with large, advanced economies such as the G7 countries.
However, it is worth noting that there is always some risk. For example, Russia has the twelfth largest economy in the world (as measured by the IMF and the World Bank in 2016), but in the late 1990s it defaulted on its domestic debt and declared a debt moratorium on its external debt (that is, it delayed its financial obligations).
Municipal bonds - classification
Municipal bonds are a type of sub-sovereign bonds. In the United States, bonds issued by the federal government are Treasury bonds.
Below the federal level, smaller branches of government also issue bonds to finance their capital spending programs. Debt securities issued by local governments such as states, cities, counties, and even schools and public airports are called municipal bonds or muni bonds.
The issue of municipal bonds is large and is estimated at several trillion dollars. In the US, interest accruing on such debt is usually exempt from federal tax, and sometimes may also be exempt from state tax.
Supranational bonds
A supranational bond is a long-term form of debt that extends beyond a single country. They are very similar to government bonds and have a high credit rating.
A good example of supranational bonds are those issued by the European Investment Bank, a long-term lending institution owned by member states of the European Union (EU).
Rating and investment in bonds
As we have established, the bondholder actually pledges money to the bond issuer. Now, when it comes to lending, one of the key things you need to know is how trustworthy the borrower is. This is where bond ratings come in.
Companies such as Moody's and Standard & Poor's provide credit rating services that are designed to help investors assess the ability of a debt issuer to meet its payment obligations.
The highest rating is AAA. Bonds rated BBB or higher are considered investment bonds. Bonds rated BB or lower are designated high yield, also known as junk bond status.
A bond that has junk bond status is considered to be at greater risk of default. This depresses the attractiveness of debt, other things being equal; consequently, the debt issuer is forced to charge a higher coupon rate in order to raise funds.
Bond trading - which bonds to buy
As mentioned earlier, when discussing the market price of bonds, the value of a bond is highly pegged to interest rates. This makes bond futures attractive to trade if you have an idea of the future performance of interest rates or if you want to hedge your exposure to interest rate risk.
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