A Few More Bond Types

On 07/23/2010, in Fixed Income, by Jordan Wilson

As Types of Bond Issues was getting long, I separated out a few of the more interesting bonds.

While the previous post listed some common bonds, I do not think too many of you will invest in Certificates for Automobile Receivables or Collateral Trust Bonds.

However, if you do any fixed income investing, you will come across the instruments below.

All of the following may be issued by governments, government agencies, and corporations.

Foreign Pay Bonds

Bonds issued by a domestic government or company, but where the interest and principal is paid in a foreign currency.

By domestic, I mean that the issuer is located in the country where the issue occurs.

When purchasing these bonds, investors must pay for them in the stated foreign currency.

For example, USA Inc. (domestic issuer) issues $100 par value 5% Euro pay (foreign currency) 10 year bonds in the USA to American investors (domestic purchasers). Investors buying the issue would pay in Euros. In turn, USA Inc. pays out its semi-annual interest payments and its repayment of principal in Euros.

Do not equate domestic with the US. The example could easily have been a German company issuing domestic bonds to German investors in US dollars, Swiss francs, Japanese yen, Canadian dollars, etc.

These bonds are of interest to domestic investors seeking exposure to foreign currencies. These investors expect the foreign currency to outperform their own over the life of the bond. If this occurs, they will earn the interest on the bond, plus obtain a gain on the currency when they convert interest and principal back into their domestic money.

These bonds may be of interest to bond issuers if they plan to use the funds for operations in the country using the foreign currency.

Foreign Bonds

The opposite of foreign pay bonds.

With foreign bonds, the issuer is foreign to the country where the issue takes place. Interest and principal of the bond are paid in the currency of the country where the bonds are issued.

For examples, Eurocorp, a company based in France, decides to tap the US domestic market for a debt issue. They issue $1000 par value 8% (USD pay) 30 year bonds to US investors.

The advantage to investors is that they can diversify their bond holdings globally, yet not worry about foreign currency exposure risks by continuing to hold domestic currency bonds.

The benefit to the bond issuer may be two-fold. One, perhaps the foreign issuer plans to use the proceeds in the market where the funds were raised. Two, perhaps the foreign company or government is located in a country with a small domestic bond market. By tapping a larger foreign market, they open up additional sources of financing opportunities.

Variable Rate Bonds

Bonds that have floating interest rates.

Interest is fixed for an initial period, often the first year of the bond’s term. After that initial period, the coupon rate fluctuates based on predetermined factors.

For example, ABC issues 10 year variable rate bonds. The terms are such that the bonds pay interest at the rate of 5% for the initial year. Afterwards, the bonds pay interest at “LIBOR plus 150 basis points” adjusted annually.

Note that the London Interbank Offered Rate (LIBOR) is a global benchmark for short term interest rates, similar to the “prime rate” in the US.

Because of the changing interest rates on the debt, these bonds are usually redeemable at par value at the lender’s option on fixed dates or periods.

These bonds are useful during periods of fluctuating interest rates or uncertainty as to future rates. You do not want to lock into a bond for a 10 years earning 5%, when general interest rates have risen to 10%.

With interest rates, you also need to consider inflation. In periods of inflation, variable rate bonds may also be a good investment to protect against inflation driving up general interest rate levels.

Real Return Bonds

Real return bonds are indexed to the inflation rate.

The objective is to ensure that nominal returns are not eroded by inflation and that investors receive a fixed real return on their investment.

Both the coupon and principal payments are indexed.

These bonds have a fixed real coupon. At each interest payment, the face value of the debt is adjusted for the cumulative inflation from the date the bond was issued. Then the real coupon rate is applied to the adjusted principal to determine the interest paid.

At maturity, investors are paid the original face value plus any cumulative inflation adjustments.

The benefit of these bonds for investors is as protection against substantial increases in inflation. When we reviewed inflation, we saw that it can impair interest income and even erode one’s original capital.

Zero Coupon Bonds

Zero coupon, or “strip bonds”, are like Treasury bills. Except much longer in term to maturity.

They do not pay any actual interest over the term of the bond.

If you think of these bonds as having no, or zero, coupon rate or that the coupon has been physically stripped from the bond, it may be easy to remember.

As an aside, if the coupons have been stripped from the bond issue, they can also be bought and sold as a separate investment.

Strip bonds are issued at a price equal to the net present value of of the bond, factoring in the term to maturity, the face value of the debt, and an implicit interest rate.

For example, you buy a 25 year, $1000 par, zero coupon bond priced to yield 11%. While the face value is $1000, you will only pay $68.77 for the bond.

You do not receive any interest receipts over the 25 years, so your purchase price is at a significant discount to make up for the lack of semi-annual cash flows.

Because of the reduced issue price, zero coupon bonds are often called “deep discount bonds”.

Note that there are also “discount bonds”. These have lower than market coupons, but do pay some interest each period. As they pay less interest than they should, they issue the debt at a discount to face value to ensure the yield to maturity is adequate to attract investors.

The difference between the price paid by the bond holder and the face value is considered as interest income for tax purposes.

Many countries require investors to pay tax yearly on the interest that is accrued each year. This would be calculated as the change in present value of the bond over the year.

Because you are paying tax on the deemed interest, you might end up with a negative cash flow each year as you pay tax without actually getting the interest.

Therefore, zero coupon bonds are most attractive to tax exempt investors or those who hold these bonds in tax deferred investment accounts.

I like zero coupon bonds when interest rates are high or are expected to fall over the coming years. As you saw in the example, for a relatively low investment, you can lock in a fixed return for a long period. In tax deferred accounts, zero coupon bonds are very useful for building long term wealth.

High Yield Bonds

Also known as “junk bonds” or “speculative grade debt”.

These bonds have been designated as non-investment grade debt by the ratings agencies. That is, these bonds have a higher risk of default than investment grade issues.

Ratings below BBB by Standards & Poors or Baa by Moody’s are considered non-investment grade bonds.

Because of the increased risk of default on interest and principal payments, high yield bonds offer higher returns than similar investment grade issues. These spreads may be up to 300 basis points (3.0% as there are 100 basis points in 1 percent interest) so the potential extra returns are attractive.

Because of the risk, I would not normally recommend purchasing individual junk bonds.

However, if you acquire a mutual or exchange traded fund that holds a wide variety of high yield debt, you can diversify away a significant portion of the higher risk and still maintain an improved yield.

That is enough on types of bonds.

Next we will look at common bond features that impact price and yields.

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