Three dials
A bond is a loan, and a loan is fully described by three things: how much (the principal), for how long (the maturity) and at what rate (the coupon). Each can be modified to build a different kind of bond, and bonds are also classified by who issues them and how creditworthy the issuer is. The types below are the ones the syllabus expects you to know.
Zero-coupon bonds
A zero pays no coupon at all during its life. It is issued at a discount to face value and redeemed at par, so the investor's whole return is the gap between issue price and redemption value. In rupee terms the return might match a coupon bond's; in risk terms it does not, because with every rupee arriving at maturity a zero has a higher duration, and therefore more interest rate risk, than a coupon-paying bond of the same maturity.
Issuers like zeroes because nothing has to be paid out during the bond's life: cash stays in the business and the loan is repaid in one bullet at maturity.
At the short end, Treasury bills from the Government of India, commercial paper from corporates and certificates of deposit from banks and financial institutions are all short-term zero-coupon instruments with maturities under one year. That makes them money market instruments, the money market being the segment of the debt market where securities of less than one year are issued and traded. At the long end, zeroes issued at a steep discount are called deep discount bonds; IDBI issued them in the past, and the Kisan Vikas Patra is another example.
In October 2009 ETHL Communications Holdings, an Essar group company, raised 4,280 crore through zero-coupon bonds secured by receivables, in two series with a maturity value of 100 each. Series 1, maturing in July 2011, was issued at 85.80 (an implied rate of 9.15%); Series 2, maturing in December 2011, at 82.55 (implied 9.25%). The longer series had the lower price and the higher implied rate, which is exactly what a discount-to-par structure should show.
Floating rate bonds
A floater's coupon is not fixed. It is reset periodically, typically every six months, with reference to a defined benchmark: an inflation index, inter-bank rates, call rates or another relevant reference. Because the coupon keeps tracking market rates, the bond's price barely needs to adjust, so floaters carry lower interest rate risk, or price risk, than fixed coupon bonds. They suit investors who expect rates to rise. Some floaters have a maximum and a minimum coupon, the cap and the floor. A housing loan with a variable rate is the everyday example, and developed markets also trade inverse floaters, whose coupons move opposite to the benchmark.
Convertible bonds
A convertible is issued as debt with the option to convert the amount invested into the issuer's equity at maturity or a later date, so it has features of both. The issue terms fix the conversion date or deadline, the conversion ratio, the conversion price (usually at a discount to market) and the proportion that converts. Conversion may be compulsory or optional, and full or partial; in a partly convertible bond the unconverted part stays as an interest-earning bond repaid at redemption. The attraction for the investor is that the instrument earns coupon income in the initial stage, usually while the company's project is still in its nascent stage, and converts into equity later if the business succeeds.
On conversion, debt leaves the balance sheet and equity capital rises, which dilutes earnings per share. The issuer benefits from a lower coupon than pure debt and from never repaying the converted principal; the cost is dilution of existing shareholders. The investor earns coupons while the project is young and later shares in appreciation and dividends.
Principal-protected notes
A PPN aims to return the principal if held to maturity. A portion of the money goes into debt structured to grow back to the full principal by the end of the term; the rest goes into equity, derivatives, commodities and other assets with high return potential. Although marketed as a debt paper, it is a synthetic product built by financial engineering from debt and derivative structures. Risk-averse investors get a shot at high returns with the downside protected. Several NBFCs have issued PPNs under names such as Equity Linked Bonds and Commodity Linked Bonds, some of them listed.
Principal protection does not mean absence of credit risk: the investor bears the issuer's credit risk in full, and the protection holds only if the note is held to maturity. An option that describes a PPN as risk-free, or as protected even if sold early, is wrong on both counts.
Inflation-protected securities
Fixed income can deliver negative real returns when inflation is high, since the nominal rate is roughly the real rate plus inflation, and a fixed nominal coupon leaves the real rate to shrink or turn negative. For retirees living on bond income that is a serious problem.
Government securities issued by the RBI in which both principal and interest are adjusted for inflation. A fixed real coupon rate is applied to an inflation-adjusted principal on each payment date. At maturity the investor receives the higher of the face value or the inflation-adjusted principal. The adjustment multiplies the principal by an index ratio, the reference index on the settlement date divided by the reference index on the issue date, and the Wholesale Price Index is the measure used.
A second instrument, the Inflation-Indexed National Saving Securities-Cumulative 2013, was a ten-year bond for retail investors (resident individuals, minors, HUFs, charities and others). It paid a fixed 1.5% plus an inflation rate based on the Consumer Price Index, compounded every six months and paid with the principal at maturity. The fixed rate acted as a floor, payable even in deflation, and the interest was taxable according to the investor's status.
Foreign currency, external and masala bonds
The classification from chapter 2 returns here. Foreign currency bonds are issued in a currency other than the issuer's home currency, usually to borrow at the lower rates of mature economies (the syllabus again cites Delhi International Airport's dollar bonds of February 2020), at the cost of currency risk to the issuer; hedging that risk with derivatives can erase the interest saving. External bonds, or euro bonds, are issued in a currency different from that of the country of issue, such as dollar bonds sold in Kuwait. Rupee-denominated external bonds are masala bonds, first issued by the International Finance Corporation in November 2014 and listed in London; they shift the currency risk to the investor.
Perpetual bonds
A perpetual has no stated maturity, so the issuer has no obligation to redeem it; investors receive periodic coupons indefinitely. If issued with a call feature the issuer can buy it back at its discretion. Indian banks have issued perpetuals to raise Additional Tier 1 capital under Basel III, and the qualifying criteria make AT1 bonds riskier than ordinary bonds.
- 1No fixed maturity date.
- 2Subordinate to deposits, loans from other banks and all other bonds.
- 3Coupon payable only out of distributable profits; no profits, no coupon.
- 4The coupon is non-cumulative: a skipped coupon is gone.
- 5The issuer can convert the bonds into equity when a pre-specified contingent event occurs.
- A bond is defined by principal, maturity and coupon; vary any of them and you get a new type. Bonds are also classed by issuer and creditworthiness.
- Zero-coupon bonds pay no coupon, are issued at a discount and redeemed at par, carry more interest rate risk than a coupon bond of the same maturity, and include T-bills, commercial paper and certificates of deposit (money market instruments under one year) and deep discount bonds at the long end.
- Floating rate bonds reset the coupon against a benchmark, typically every six months, so they carry lower price risk and suit rising rates; caps and floors bound the coupon; inverse floaters move against the benchmark.
- Inflation indexed bonds adjust both principal and coupon by an index ratio based on WPI and pay the higher of face value or adjusted principal at maturity. AT1 perpetual bonds have no maturity, rank below deposits and other bonds, pay non-cumulative coupons only from distributable profits, and can be converted to equity on a trigger event.