Investing in bonds can be a good option for moderate and conservative investors seeking to generate passive income streams for a fixed period or preserve their accumulated wealth or earnings while giving them better chances at beating inflation.
Holding bonds is also essential in portfolio diversification. However, with different types of bonds to choose from, it can be difficult where to begin. This article provides a definitive guide to the different types of bonds and their respective characteristics.
A Guide to the Different Types of Bonds
Based on the Nature of the Issuer
Several entities are authorized to issue bonds as part of their fund-raising activities. These entities range from governments to corporations. Each also represents a particular type of bond categorized according to the nature of the issuer. Take note of the following:
• Government Bonds: These bonds are issued by a sovereign national government. They are also called sovereign bonds and are issued to finance public projects and programs. In the United States, the bonds issued by the federal government under the Department of Treasury are called Treasuries.
• Municipal Bonds: Local government units or subdivisions within a country such as cities or federal states can also issue so-called municipal bonds to raise funds needed to finance public projects within their jurisdictions. The bonds issued by special districts are also often referred to as municipal bonds.
• Corporate Bonds: One of the most common types of bonds is corporate bonds. These are issued by business organizations or corporations to raise capital or secure financing from the bond market and the participating investors. The funds are used to finance their operations or pursue business expansion plans.
• Supranational Bonds: These bonds are issued by supranational organizations such as the World Bank, the International Monetary Fund, the European Investment Bank, and the Asian Development Bank. Supranational organizations are formed by multiple sovereign nations to promote economic cooperation and development.
Based on Evidence of Ownership
Holding a bond means that the bondholders own the right to receive debt repayments and interests from the issuer. The following are the different proofs of ownership, and each has been used to categorize different types of bonds based on evidence of title:
• Registered Bonds: Bonds whose ownership and subsequent purchaser are recorded by their issuers or transfer agents are called registered bonds. These bonds are not easily transferable to other potential holders because they need to be sent back to the bond issuers for cancellation and the issuance of newer ones.
• Bearer Bonds: A bearer bond is an official certificate issued without a named holder. The person who holds this certificate can claim the value of the bond and the rights attached to it. Bearer bonds can be traded like cash because they are registered with a control number to prevent counterfeiting.
• Book-Entry Bonds: Some bonds do not have a paper certificate. The ownership of these bonds is documented or recorded in an electronic database or computer record. These are called book-entry bonds or paperless bonds. These bonds have become common due to the rise of online brokerage and trading platforms.
Based on Security and Risk
There are also two categories of bonds that are classified according to their level of security. These are secured bonds and unsecured bonds. Take note of the respective definitions, characteristics, differences, and examples:
• Secured Bonds: These bonds are backed by specific collateral, which reduces the risk for their bondholders. Holding a secured bond means that the bondholder can claim the collateral if the issuer defaults. Examples include mortgage-backed securities, collateralized mortgage obligations, and equipment trust certificates.
• Unsecured Bonds: These bonds are called “unsecured” because, unlike secured bonds, they are not backed by collateral. Bondholders rely on the ability of the issuers to pay based on their credit rating. Specific examples of unsecured bonds include government bonds such as U.S. Treasuries, municipal bonds, and corporate bonds.
Secured and unsecured bonds provide a brief overview of their respective levels of risk. Other bonds have been attached with labels to help potential investors have a quick grasp on the level of risks associated with purchasing and holding such. Below are the examples:
• Senior Bonds: A senior bond is a bond that has a higher priority claim on the assets and income of the bond issuer compared to other bonds issued by the same issuer. Holders of these bonds or so-called senior bondholders have a super claim over other bondholders in case the issuer defaults or when it becomes bankrupt.
• Subordinated Bonds: These bonds have a lower priority claim on the assets and income of the issuer than other bonds. Holders of these bonds are also placed at the bottom of the entire hierarchy of creditors. These investors might receive less or none at all in case the issuer becomes illiquid or ends up bankrupt.
• Junk Bonds: Junk bonds are also called high-yield bonds. These bonds promise coupon rates and overall yields that are higher than benchmarks. The problem with these bonds is that credit rating agencies give them low investment grades because of uncertainties surrounding the long-term financial capabilities of their issuers.
Based on the Underlying Assets
It is also important to note that asset-backed securities and covered bonds are subtypes of secured bonds. Remember that these bonds are backed by the underlying cash flows from other assets. There are different types of secured bonds. Take note of the following:
• Mortgage-Backed Securities: These asset-backed securities are secured by a mortgage loan or collection of mortgages. The mortgages are aggregated and sold to a group of individuals, such as a government agency or investment bank, which then securitizes or packages the mortgages into a security that investors can buy.
• Collateralized Mortgage Obligations: These represent another type of asset-backed security. They are created by pooling together a large number of individual mortgage loans and then dividing them into separate tranches with different levels of risk and return. Each tranche has a different maturity date and interest rate. Investors can choose to invest in one or more tranches based on their risk tolerance and desired return.
• Collateralized Debt Obligations: These are similar to collateralized mortgage obligations. However, instead of mortgages, they are backed by a pool of various debt securities such as bonds, loans, and other types of fixed-income instruments. The pool is diversified across different issuers, industries, and credit ratings to reduce risk.
• Equipment Trust Certificates: These are another type of secured bond issued by a corporation and backed by a pledge of large equipment, such as airplanes, railroad cars, and ships. Their security is based on the fact that the trustee has legal title to the equipment. The trustee will take possession of the equipment and sell it to pay off the bondholders if the issuing company defaults on its obligations.
• Covered Bonds: These are similar to mortgage-backed securities and other asset-backed securities because these bonds are backed by cash flows from mortgages or public sector assets. The main difference between covered bonds and asset-backed securities is that the assets remain on the balance sheet of the issuer.
Based on Term or Maturity
Most bonds are created and issued with a stated date of maturity. The typical maturity date is five years but some have longer terms and a few have perpetual holding periods. Take note of the following types of bonds based on term or maturity:
• Straight Bonds: A straight bond is a basic type of bond that has constant coupon payments, face value or par value, purchase value, and maturity date. It has no special features compared to other types of bonds with embedded options. Straight bonds are also known as plain vanilla bonds or bullet bonds. These bonds can also be classified as short-term, medium-term, or long-term bonds depending on their tenure.
• Short, Medium, Long Bonds: Short bonds are the most common type of bonds. They have a maturity date of under 5 years. Bonds that mature after 5 or under 15 years are called medium bonds and those that mature after 15 years or more are called long bonds. Take note that there is no consensus as regards the exact number of years for a bond to be considered a short, medium, or long bond.
• Perpetual Bonds: These bonds have no maturity date. Bondholders hold them for as long as they please. The absence of maturity dates means that these bonds can also be treated as equities and not as debts. These bonds are also called perpetuities or perps. Some ultra-long bonds that last centuries can be technically considered perpetuities from both financial and practical perspectives.
• Methuselah Bonds: Other long bonds have also been referred to as Methuselah bonds or Methuselahs. These bonds mature after 50 years or longer. Note that the name is a reference to the religious figure mentioned in the Hebrew Bible named Methuselah who was considered the oldest person in the biblical narrative. The demand for longer-dated assets from pension plans has increased the issuance of Methuselahs.
• Serial Bonds: These bonds mature in installments over a specified period. This means that has a staggered schedule of maturity dates. A serial bond has several portions that mature at intervals over its entire lifetime. The issuer of this bond has to repay a portion of the principal to the bondholder on specified dates until it completely matures. Issuing serial bonds has the advantage of easing the debt load.
Based on Applied Conditions
Investors should also be aware of the different conditions stated in each bond. These conditions pertain to the amount of coupon rate or the manner in which these coupons are paid. Below are the specific types of bonds based on the applied conditions:
• Fixed-Rate Bonds: Bonds that have a fixed coupon rate or interest rate that remains constant throughout their lifetime are called fixed-rate bonds.
• Stepped-Coupon Bonds: These are somewhat similar to fixed-rate bonds but their coupon rate increases during their lifetime.
• Floating Rate Notes: Some bonds have a variable coupon that is linked to a reference of interest such as Libor or Euribor. These are called floating rate notes.
• Zero-Coupon Bonds: These bonds do not pay regular coupons. They are issued at a substantial discount to the par or face value.
• Inflation-Indexed Bonds: Bonds with the principal amount and coupon payments indexed to the level of consumer prices are called inflation-indexed bonds.
• Lottery Bonds: These bonds are issued by European countries. The coupon is fixed but redemption is picked from random bondholders according to schedule.
Based on Embedded Options
Some bonds also have provisions, called embedded options, that give the issuer or bondholder the right to take certain actions at specific points in time. These bonds can provide some convenience and protection. Take note of the following:
• Callable Bonds: These bonds have an embedded call option that gives their issuers the right to redeem them before their maturity dates. These are also called call bonds. The redemption is usually done at a premium price. Specifically, when an issuer calls a bond, it pays the bondholder the call price, which is usually based on the face value, together with accrued interest to date.
• Puttable Bonds: Bonds that have an embedded put option are called puttable bonds or put bonds. A put option gives the bondholders the right, but not the obligation, to sell the bonds back to the bond issuers before their maturity date at specified dates regardless of the reason. This is done at a specified price called the put price which is usually equal to the amount of the face value.
• Convertible Bonds: These bonds allow their bondholders to convert them into a predetermined number of shares of common stock of the issuing companies. Converting these bonds into shares would result in bondholders losing their right to interest payments and principal. Convertible bonds are considered hybrid securities because they combine the features of equities and bonds.
• Exchangeable Bonds: Bonds that can be converted into the shares of companies other than their respective issuers are called exchangeable bonds. These companies are usually subsidiaries of the issuers or corporations in which a particular issuer holds a stake. Conversion is done at some future date and under prescribed conditions. These bonds are also considered hybrid securities.
Based on Special Use Cases
Several entities issue bonds for special use cases. These use cases differ from the conventional and general fund-raising purposes of governments and corporations. These bonds are called special bonds. The following are their specific subcategories:
• Green Bonds: Some governments and corporate entities have issued so-called green bonds to fund projects and programs that have positive environmental benefits. Bonds raised for climate change mitigation are called climate bonds.
• Social Bonds: These are non-tradeable bonds issued as part of outcomes-based contracting in which governments or nonprofits repay their private investors after succeeding in achieving predefined outcomes.
• Catastrophe Bonds: Catastrophe bonds or cat bonds are risk-linked bonds that transfer a specified set of risks from a sponsor to an investor. Insurance companies first issue these bonds to lessen their risks from catastrophic events.
• Sustainability Bonds: These bonds combine the purpose or use cases of green bonds and social bonds. They are issued to finance projects and programs aimed at promoting sustainability in the environment and communities
• War Bonds: Several governments have financed their military operations and other expenditures in times of war without raising taxes using war bonds. These bonds often have a low interest rate and can be called back.