Bond Categories in a Developed Bond Market
By Acceler8now.com Bond Investing Team, August, 2007
While "charity begins at home", investing is a global endeavour, which is why investors are found crossing international borders to find good investment opportunities wherever they exist. In some cases, investors in very developed markets still go seeking some fortune in more risky emerging markets. In that spirit, nothing limits you to the Nigerian bond market, especially if you desire a broader array of debt securities to pick from. That's good reason to take this satellite view of bond-investing, examining what bond options there are in developed bond markets. That possibly helps us focus on critical questions as to why our market is relatively laid-back. And, if we will consider playing in the international bond market, it arms us with a better understanding of the dynamics of bond investing.
Bonds can be classified on the basis of:
- The Issuer
- The Coupon type
- Redemption Clause
- Others
Major issuer classifications are:
- Government bonds. These are bonds issued by the Federal Government. This is the bond type you will easily buy in Nigeria at this time. Such bonds are backed by the full faith and credit of the Federal Government and charged upon the general assets of the State. Generally, they are seen as a risk-free investment, or more appropriately, low risk investment. Their credit rating is therefore very high, making them high quality bonds. The downside is the relatively lower yield that is likely to be earned on account of that quality. In most cases, such bonds enjoy a tax benefit, being exempt from tax.
- Municipal bonds are issued by a state or local council authority. In Nigeria, states like Abia, Delta, Edo, etc, had in the past issued bonds to finance development. They could also offer tax incentives. Because of the limited resources of a state or local government, the default risk is higher that with the Federal bonds. They will therefore be expected to offer higher returns.
- Corporate bonds. These are bonds of corporations. Their qualities differ as much as you have companies of different credit ratings. Some corporate bonds are of very high quality because of the high credit rating of the issuing companies. At the other extreme are very poor quality bonds issued by companies of poor credit rating. These junk bonds make for more of speculation that proper investing.
- Government Agency bonds are those issued by government agencies where this is permitted. Major utilities can, for instance, can raise funds to drive major projects, by issuing bonds.
- International bonds are intended, ab initio, for the international market and may be issued by governments or corporations. Eurobonds fall into this category. Such bonds are issued in a foreign currency so as to allow the issuer access to capital from other markets. A Eurodollar bond is issued outside the US, but denominated in dollar.
Main Coupon Rate Classifications are:
- Fixed-rate bonds. These are bonds that pay a fixed coupon through the life of the bond, usually disbursed at half-yearly intervals. The principal and final interest payment are received at maturity. The income stream from this class of bonds is definite, making them typically fixed-income securities. This is the most familiar bond type.
- Floating Rate bonds. These bonds have a coupon that is tied to a specific index or other benchmark, for example, the Treasury bill rate. The coupon is usually stated as "index/benchmark (example T/Bills rate) plus or minus x%". An example is 'Treasury Bill rate + 3%'. This coupon structure makes such bonds, also called floaters, easily responsive to market interest rates. The outcome is that the interest to be received could vary over time, depending on the movement of the benchmark, which on its part responds to market changes.
- Zero Coupon bonds. Here, there is no periodic interest payment, hence the tag 'zero-coupon'. The investor gets his reward by way of a discount, at purchase, on the par value of the bond. In effect, the purchase price is a discounted sum, below the par value. At maturity, the investor receives his principal investment plus the interest, since the amount he is paid is the par value. Zero-coupon bond obviously does not serve the goal of a regular stream of income that is one of the factors that can attract to investment in bonds. However, it works well when your objective is to save for a specific purpose to be met at a particular future period, since it is at that point that an inflow is important.
- Inflation adjusted/linked Bonds. These are bonds with an in-built mechanism to absorb the impact of inflation. They consequently provide a fixed yield plus a factor, being the current rate of inflation. This is an attempt to maintain the real value of the investors investment.
Classification on the basis of redemption has these main groupings:
- Callable bonds are bonds with a call feature. Bonds with such callability option permit the issuer to call the bond - that is, to repay the bond before its stated maturity. Call conditions are specified for such bonds, for example, the call date, whether to be repaid at a premium or not, etc. The call date can be a specific single date (called European callable), several dates (Bermudan callable) or be at any time before maturity (American callable).
- Puttable bonds provide the reverse feature, allowing the bondholder to compel repayment before maturity. Here again, 'conditions apply', for instance, as to put dates.
- Convertible bonds are those that allow the holder to convert to ordinary shares, if he chooses to. The terms of such conversion will be spelt out and an investor may opt to exercise the right or wait to be repaid at maturity.
Others:
 Bonds are also given some other classifications, based on different factors. High-yield bonds are bonds that offer very high returns, simply because they are of poor quality - issued by corporations of the lowest credit ratings. These are also called junk bonds. They are seen as speculative bonds, bought by investors with high risk tolerance. The reverse are investment grade bonds that have good credit rating. Some bonds may have a lower priority status in event of liquidation of the issuer. What this means is that their claim to repayment is lower than those of some other bonds, called senior bonds. The 'inferior' bonds are referred to as subordinated bonds and will be repaid only if and when the senior bonds have been repaid.
So, that's it. As an investor, you need all the knowledge. You can also be a global investor, putting your money to work wherever there are opportunities. That requires some level of familiarity with global practices. We also continue to hope that our local market sees more growth, in terms of the volume of instruments available and also as to the variety. Investors have different circumstances and needs, making a straight-jacketed market far short of the ideal. The more investors can find products that approximate their personal situations and needs, the more likely they will embrace the market to meet their invesment needs. That too will re-inforce the growth of the market.
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