Types of bonds

There are many types of bonds that can be issued, each of which is tailored to the specific needs of either the issuer or investors. The large number of bond variations is needed to create the best possible match of funding sources and investment risk profiles.

When an issuing entity (usually a corporation) sells a fixed obligation to investors, this is generally described as a bond. The typical bond has a face value of $1,000, which means that the issuer is obligated to pay the investor $1,000 on the maturity date of the bond. If investors feel that the stated interest rate on a bond is too low, they will only agree to buy the bond at a price lower than its stated amount, thereby increasing the effective interest rate that they will earn on the investment. Conversely, a high stated interest rate can lead investors to pay a premium for a bond.

When a bond is registered, the issuer is maintaining a list of which investors own its bonds. The issuer then sends periodic interest payments directly to these investors. When the issuer does not maintain a list of investors who own its bonds, the bonds are considered to be coupon bonds. A coupon bond contains attached coupons that investors send to the issuer; these coupons obligate the company to issue interest payments to the holders of the bonds. A coupon bond is easier to transfer between investors, but it is also more difficult to establish ownership of the bonds.

There are many types of bonds. The following list represents a sampling of the more common types:

  • Collateral trust bond. This bond includes the investment holdings of the issuer as collateral.

  • Convertible bond. This bond can be converted into the common stock of the issuer at a predetermined conversion ratio.

  • Debenture. This bond has no collateral associated with it. A variation is the subordinated debenture, which has junior rights to collateral.

  • Deferred interest bond. This bond offers little or no interest at the start of the bond term, and more interest near the end. The format is useful for businesses currently having little cash with which to pay interest.

  • Guaranteed bond. The payments associated with this bond are guaranteed by a third party, which can result in a lower effective interest rate for the issuer.

  • Income bond. The issuer is only obligated to make interest payments to bond holders if the issuer or a specific project earns a profit. If the bond terms allow for cumulative interest, then the unpaid interest will accumulate until such time as there is sufficient income to pay the amounts owed.

  • Mortgage bond. This bond is backed by real estate or equipment owned by the issuer.

  • Serial bond. This bond is gradually paid off in each successive year, so the total amount of debt outstanding is gradually reduced.

  • Variable rate bond. The interest rate paid on this bond varies with a baseline indicator, such as LIBOR.

  • Zero coupon bond. No interest is paid on this type of bond. Instead, investors buy the bonds at large discounts to their face values in order to earn an effective interest rate.

  • Zero coupon convertible bond. This variation on the zero coupon bond allows investors to convert their bond holdings into the common stock of the issuer. This allows investors to take advantage of a run-up in the price of a company's stock. The conversion option can increase the price that investors are willing to pay for this type of bond.

Additional features can be added to a bond to make it easier to sell to investors at a higher price. These features can include:

  • Sinking fund. The issuer creates a sinking fund to which cash is periodically added, and which is used to ensure that bonds are eventually paid off.

  • Conversion feature. Bond holders have the option to convert their bonds into the stock of the issuer at a predetermined conversion ratio.

  • Guarantees. The repayment of a bond may be guaranteed by a third party.

The following additional bond features favor the issuer, and so may reduce the price at which investors are willing to purchase bonds:

  • Call feature. The issuer has the right to buy back bonds earlier than the stated maturity date.

  • Subordination. Bond holders are positioned after more senior debt holders to be paid back from issuer assets in the event of a default.

Related Courses

Corporate Cash Management 
Corporate Finance 
Treasurer's Guidebook