[MUSIC PLAYING] This is Dr. Bob Nolley, continuing our discussion on bonds with some details on different types of bonds. In our discussion of finance, we've said that very frequently products find their way to the market when there is a vacuum. The bond market is no exception.
One type of bond is the government bond. We consider a government bond to be issued by the US government. They can be issued by any national government. Outside of the US, they are called sovereign bonds.
In the US, government bonds are usually referred to as risk-free bonds because the government can raise taxes or create additional currency in order to redeem the bond at maturity.
Zero coupon bonds or an instrument that was first introduced in the '60s and became popular in the '80s. Zero coupon bonds are also called discount bonds. And the reason it's called a discount bond is because it does not make periodic interest payments. The coupon rate is zero.
Examples of these are US savings bonds and some long-term zero coupon bonds. With a zero coupon bond, the investor does not receive coupon payments, but does receive the face value in full at maturity.
A note about zero coupon bonds-- because they pay zero interest they are issued at a substantial discount to face value so that the interest is effectively included in what gets paid at maturity.
We have often made the point that coupon rates are most often fixed. And there are bonds that have variable coupon rates, however. These are called Floating Rate Bonds, or FRBs.
The spread is the rate that is tied to an index like the Fed funds rate. They have quarterly coupons. In the US, government-sponsored enterprises like the Federal Home Loan Bank, the Federal National Mortgage Association, and the Federal Home Loan Mortgage Corporation, also called Fannie Mae and Freddie Mac, are issuers of floating rate bonds.
A note about these floating rate bonds. Floating rate bonds have very little interest rate risk where the market rates are the actual expected coupon rates of the floating rate bonds. This is different than a fixed rate bond whose prices decline when market rates rise. For this reason, there is almost zero interest rate risk.
There are several other types of bonds as well. There are inflation linked bonds that are floating rate bonds with an index that is tied to the inflation rate. Convertible bonds let the bond holder trade the bond for a number of shares of common stock. Asset-backed securities are bonds whose cash flows are backed by the output of other assets, like mortgage-backed securities. Subordinated bonds are a type that have a lower priority than other bonds in the case of liquidation. These bonds would typically have a slightly higher return in order to compensate the holder for the increased default risk.
Now let's review. We have government bonds issued by national governments. They are also called sovereign bonds. We have zero coupon bonds that have no coupon payment and therefore sell at a deep discount below face value.
There are also floating rate bonds that are fixed to an index. Issuers of these include Fannie Mae and Freddie Mac. And other types of bonds include inflation-linked bonds, convertible bonds, and asset-backed securities, and subordinated bonds.
This is Dr. Bob Nolley. And in the next lesson, we'll talk about how we can place a value on bonds.
[MUSIC PLAYING]
