In this lesson, you will learn about different types of bonds. Specifically, this lesson will cover:
- Government Bonds
- Zero-Coupon Bonds
- Floating-Rate Bonds
- Other Types of Bonds
1. Government Bonds
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, but they actually can be issued by any national government.
Outside of the United States, 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.
- Government Bond
- A bond issued by a national government denominated in the country’s domestic currency.
2. Zero-Coupon Bonds
Zero-coupon bonds are an instrument that was first introduced in the 1960s and became popular in the 1980s.
Zero-coupon bonds are also called discount bonds, and the reason it's called a discount bond is that it does not make periodic interest payments; the coupon rate is zero.
With a zero-coupon bond, the investor does not receive coupon payments, but does receive the face value at maturity.
Because zero-coupon bonds 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.
- Zero-Coupon Bond
- A bond with no coupon payments, bought at a price lower than its face value, with the face value repaid at the time of maturity.
3. Floating-Rate Bonds
While coupon rates are most often fixed, there are bonds that have variable coupon rates. These are called floating-rate bonds, or FRBs. The spread is the rate that is tied to an index like the federal funds rate, and they have quarterly coupons.
In the US, issuers of floating-rate bonds are government-sponsored enterprises, such as:
- Federal Home Loan Bank
- Federal National Mortgage Association (also called Fannie Mae)
- Federal Home Loan Mortgage Corporation (also called Freddie Mac)
Floating rate bonds have very little interest rate risk when the market rates are the actual expected coupon rates of the floating rate bonds. This is different than fixed-rate bonds, whose prices decline when markets rate rise. For this reason, there is almost no interest rate risk with floating-rate bonds.
- Floating-Rate Bond
- A bond that has a variable coupon equal to a money market reference rate (e.g., LIBOR), plus a quoted spread.
4. Other Types of Bonds
There are other several types of bonds as well.
Other Types of Bonds
Floating rate bonds with an index that is tied to the inflation rate.
Bonds that let the bondholder trade the bond for a number of shares of common stock.
Bonds whose cash flows are backed by the output of other assets, like mortgage-backed securities.
Bonds that have a lower priority than other bonds in the case of liquidation. These bonds would typically have a slightly higher return to compensate for the increased default risk.
- Inflation-Linked Bond
- A floating-rate bond with an index that is tied to the inflation rate.
- Convertible Bond
- A bond that lets the bondholder trade the bond for a number of shares of common stock.
- Asset-Backed Security
- A bond whose cash flows are backed by the output of other assets, like mortgage-backed securities.
- Subordinated Bond
- A bond that has a lower priority than other bonds in the case of liquidation.
In this lesson, we learned that we have government bonds issued by national governments. These 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 bonds include Fannie Mae and Freddie Mac. Other types of bonds are inflation-linked bonds, convertible bonds, asset-backed securities, and subordinated bonds.
Best of luck in your learning!