Bonds are financial securities that provide regular income, preserve capital and protect against market volatility. There are many types and qualities of bonds, each tailored to the needs of their issuers.
Bonds are issued by governments, corporations, agencies, municipalities and foreign nations. Each type has its profile of risks, interest rates and times to maturity.
A fixed-rate bond is an investment vehicle that pays a predetermined interest on a scheduled basis until it matures. These investments are a great way to lock in a guaranteed return for a set period, usually between one and five years.
However, they come with risks and may only be a good choice for some. Considering your savings needs and term length before investing in a fixed-rate bond would be best.
Floating-rate bonds, on the other hand, can adjust their rates to reflect market conditions. This allows them to provide a higher return when prevailing interest rates are high and lower yields when prevailing rates are low.
A floating rate bond, also called a floater, is an investment that pays interest on an adjustable basis. These bonds are issued by governments, corporations and financial organizations for tenures ranging from 2 to 5 years.
Floating-rate bonds usually pay higher yields than traditional fixed-rate bonds. However, they are more impacted by market rate changes than fixed-rate bonds.
Investors who believe interest rates and inflation will rise may consider investing in a floating-rate bond. However, investors should be aware that a callable floater can potentially lose value before maturity. This type of risk is called risk and is a significant concern for investors.
Zero Interest Rate Bonds, or discount bonds, are debt instruments that trade at a deep discount to their face value. These bonds pay no interest until maturity when they are paid back to the holder.
Investors looking to invest for long-term goals, such as retirement, a child's education and marriage, may consider investing in these bonds. They have a 10 to 15 years maturity and offer a safe and secure investment.
In addition to their low risk, zero coupon bonds provide investors with a return on their investments in real terms, without inflation adjustment. These bonds are generally issued by the federal government and are popular among pension funds and insurance companies because of their high duration - they help immunize them from interest rate risk on their long-term liabilities.
Inflation Linked Bonds (ILBs) are fixed-income securities that adjust coupon and principal payments to reflect inflation. This makes them attractive to investors who want the stability of a fixed-income investment but are concerned about inflation risk.
These bonds are indexed to the Consumer Price Index, or CPI, which measures changes in the prices of goods and services.
Inflation is a significant concern for many investors, as it degrades the purchasing power of money over time. Investments that target actual returns--the amount earned after adjusting for inflation- can protect investors against this loss and potentially increase their future purchasing power.
Perpetual bonds are a unique type of bond that doesn't have a maturity date. These bonds only pay interest once the bond issuer redeems them, usually at a later date.
Banks and government entities typically issue these bonds to fulfil their Tier 1 capital requirement. These types of bonds also serve as an attractive source of long-term financing.
Because they are priced similarly to stock dividend payments, perpetual bonds are assigned a value based on their nominally fixed coupon amounts divided by a constant discount rate representing the speed at which money diminishes in value over time (partly due to inflation). This denominator ultimately reduces the value of these minimally fixed coupon amounts until the value becomes worthless.
Subordinated bonds are unsecured debts issued by a company or government entity. These bonds are ranked below all existing and future senior debt, meaning holders can only claim their principal if the issuer goes bankrupt.
Equity kickers or additional benefits usually accompany these bonds to compensate the lender for the higher risk. They are also sometimes issued as a part of a securitization deal.
Banks commonly use subordinated debt to finance large corporations that require capital but have a high DSCR and sufficient cash flow. It is also a smart option for issuers as they can use it to help meet their long-term capital requirements.