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Different Types of Bonds

by David Garner - 02.07.2014

The Different Types Of Bonds for Investment

Bonds are regarded as a low-risk asset class that should form part of any diverse investment portfolio. However, it is a mistake to regard all bonds in the same way, as bonds from the various sectors of the market have very different characteristics.

You can choose from government, corporate, sub-sovereign and asset-backed bonds for your portfolio. Within each of the categories you will find bonds with a whole range of coupon rates, maturities, yields and credit ratings.

As with any kind of investment decision, research, market knowledge and an awareness of how much risk you can take on are key to making the right choices about which bonds to buy and sell.

Government Bonds

Government bonds are issued by central governments when they need to borrow money, either to fund new spending or to re-finance existing debt. Bonds issued by governments of countries with established stable economies, such as the US, Germany and the UK are generally regarded as having the lowest credit risk of any type of investment, but the downside of that is the fact the coupon rates are typically very low.

Almost all governments issue bonds to raise funds, but not all of them should be viewed as a low credit risk. Those issued by emerging economies carry a high risk of default, as do those from countries with serious economic problems. However, this is reflected in the yield, as the higher risk bonds also offer the chance for big returns. For example, at the time of writing, Greek government 10-year bonds had a yield of 11.13% and the equivalent Brazilian bonds were 9.39%, but the yield on 10-year German bunds was just 1.42%.

The government bonds most often bought by investors are US Treasuries, UK gilts, German bunds and French OATs. They are available with a variety of terms, from two years to 30 years, and also in a range of forms.

Many of the bonds are structured in the conventional way, with a fixed coupon paid either annually or every six months, along with a set maturity date for the principal to be repaid. There are also floating-rate bonds (often referred to as floating-rate notes), in which the coupon varies in line with the movements of a benchmark, such as the London Interbank Offered Rate (LIBOR). Some governments issue zero-coupon bonds, which do not have regular coupon payments, but pay all the interest as a lump sum on maturity.

Another common type of debt instrument is index-linked government bonds, in which the coupon rate is directly linked to inflation. These bonds can offer protection against inflation over the longer term, but may produce relatively poor short-term returns during periods of low inflation.

One thing that all government bonds from nations with established and stable economies have in common is that individual investors rarely hold them until maturity (with the notable exception of index-linked bonds purchased for retirement planning). While it may make sense for institutional investors to hold some ultra-safe government bonds to maturity as part of fund portfolios, the returns are too small to tempt most individuals.

Instead, they look to make money by buying and selling bonds. The price of government bonds on the secondary market changes in response to fluctuations in the prevailing interest rates, so investors can make profits from trading. To do that they need to be aware of the inverse relationship between interest rates and bond prices, as well as the factors that influence interest rates in both the short and long term.

Corporate Bonds

Corporate bonds are a debt instrument used by companies to raise funds, usually for capital expenditure, product launches or acquisitions. They are effectively IOUs, which pay interest at set intervals and are repayable in full on a set date.

The sector is split in to two categories, investment grade and high-yield (also known as speculative grade) bonds. This depends on the credit rating of the issuer and the specific bond, with those regarded as low-risk being described as investment grade and those from start-ups or companies with financial problems viewed as high-risk and categorised as speculative grade.

Corporations issue a number of different types of bond, including conventional and floating-rate bonds. Some also issue convertible bonds, which have a low coupon and an option that allows the bondholder to swap the principal for a set number of shares at a fixed point during the term.

Some corporate bonds feature a call option, which entitles the issuer to repay the principal before maturity and avoid future coupon payments. The terms and conditions for call options vary, with some having a specific window for the issuer to exercise it and others protecting against it for the first two or three years of the term.

The attraction of call options to issuers is that they allow them to cancel bonds with high coupons if interest rates fall, and then replace them with cheaper debt by issuing new bonds at a lower rate. That scenario damages returns for investors, as they may have to reinvest the principal from the called bonds in securities with lower yields. It also means bonds with call options do not increase in price as much as conventional bonds when interest rates fall.

For those reasons, callable bonds must offer higher yields than non-callable ones to make them tempting to potential investors. However, it is important to know the yield to call figure before deciding whether to invest.

Some corporate bonds have put options, which allow the bondholder to redeem the security and have the principal repaid by the issuer, along with any accrued interest, before maturity. Such bonds usually have specified windows in which the bondholder can demand that the debt be repaid. The benefit to investors of these bonds is that they can cash out and reinvest their money if interest rates rise, but because that puts the issuer at a disadvantage, they usually have a lower yield.

There are a number of reasons why investment grade corporate bonds are appealing to investors. They have the potential for better returns than government bonds and are a stable source of regular income, as well as being useful for diversifying portfolios, as they offer the opportunity to invest in a variety of industry sectors. There is also strong demand for corporate bonds on the secondary market, so most can be sold on relatively easily and quickly.

Despite these benefits, many individual investors avoid direct involvement in the corporate bond market. This is partly for practical reasons, as there is no central market for trading and most deals are done over-the-counter with the bondholder selling directly to the buyer. This usually involves brokers and bond dealers trading debt securities electronically, so individuals generally need to use a broker in order to trade.

Risk is another important factor in this, as corporate bonds are usually in quite large denominations and require a significant level of initial capital. While investment grade corporate bonds have high credit ratings, it is not unknown for major companies with AAA status to run into significant difficulties and default on their debts. Although institutional investors can absorb that kind of loss, very few individuals can.

Investors who wish to diversify their portfolio using corporate bonds often choose to do so via bond funds or unit trusts. This allows them to spread their risk and also requires less effort than trading in individual bonds.

High-Yield Bonds

High-yield bonds are corporate debt securities that are viewed as being speculative grade by credit ratings agencies. Typically, the issuer is a start-up or young company, a corporation that has experienced financial problems, a firm involved in a troubled industry or a company engaged in a leveraged buyout.

These bonds have a much greater risk of default than investment grade corporate bonds, but that is not the only risk associated with them. Investors must also consider what may happen in the event of the corporation being further downgraded by the ratings agencies, together with the impact of economic conditions and one-off company-specific events.

As with all fixed-income securities, there is a risk of prices falling due to fluctuations in interest rates, but this is an even more important factor with high-yield bonds. Their credit ratings or the identity of the issuer can put other investors off, so it is not always easy to sell them on. As high-yield bonds are typically less liquid than investment grades, holders often face the choice of offloading them at a discounted price or retaining them even though there are better returns available elsewhere.

There are also a number of advantages to buying this sort of bond, including that they offer the prospect of higher returns. As issuers have to pay larger coupons to attract investors, the regular interest payments from high-yield bonds are a good way for an individual to increase short-term income from their portfolio. The total returns from high-yield bonds held to maturity should also be significantly higher than those from investment grade securities.

High-yield bonds issued by rapidly growing companies are likely to experience healthy price growth, particularly if they receive a ratings upgrade and the markets no longer regard them as risky. For similar reasons, convertible bonds issued by start-up technology or biosciences firms may be an attractive option, as the share price will grow as the company does.

One key characteristic of high-yield bonds is that their performance does not always correlate with that of other bond types, as underlying factors related to the issuer can have more influence on their price than prevailing interest rates. As such, they can be good for diversification within a portfolio.

Individual investors do buy high-yield bonds directly, but only if they are in a position to cope with the associated risk and absorb the potential loss of the principal. It is more common for individuals to participate in this sector of the market by investing in specialist high-yield bond funds.

Sub-Sovereign Bonds

Sub-sovereign bonds are similar to government bonds, but are not issued by central government. The issuer could be a region, state or municipality, although the largest sector of the market is supranational institutions, such as the World Bank, European Investment Bank and Inter-American Development Bank.

This is a growing market, as recent years have seen sub-sovereign entities turn to bonds as a way of raising funds for infrastructure projects and to run public services. There are also examples of central governments creating quasi-government agencies to deal with specific problems and funding them via bond issues, such as the KfW in Germany, which provides finance for housing and loans to small businesses.

Sub-sovereign bonds work in the same way as standard government bonds, but do not necessarily enjoy the same high credit ratings. The major ratings agencies assess each issuer individually and while some sub-sovereign bonds receive AAA status, others are viewed as having a greater degree of risk.

Asset-Backed Bonds

Asset-backed bonds are a type of collateralised debt instrument. They involve a process known as securitisation, in which companies or special purpose vehicles buy up assets such as loans and then issue tradable bonds backed by those assets.

The best-known collateralised debt instruments are mortgage-backed securities, which became the focus of global attention in 2007 when banks made huge losses on sub-prime mortgage bonds, triggering a global financial crisis. The market for mortgage-backed securities has started to pick up again, but many investors remain understandably wary of them.

However, there is a well established market in asset-backed bonds, which are backed by non-mortgage financial assets. Typically, they are based on credit card receivables, car, personal and business loans, and leases for equipment, although they can be backed by any asset that has a revenue stream.

Asset-backed bonds are attractive to investors as they are low-risk, due to them being secured by collateral, but have higher yields than other securities with comparable credit ratings, such as UK, US and German government bonds. They also benefit from credit enhancement, which can take the form of subordination, over-collateralisation or bond insurance.

This sector of the bond market is very diverse, as there is a wide selection of maturities and yields available, and the assets used come from a number of industries. There are several different types of asset-backed bonds, including amortising securities that repay the principal in instalments over the term of the bond and bullet structures that return the principal in a lump sum.

Written by David Garner

David is a Partner with leading UK based real estate investment consultancy DGC Asset Management Limited. Since 2001 David has advised Investors on a range of niche real estate acquisitions and developments in the agriculture and distressed asset space with a gross development value exceeding £100 million.