Types of Bonds
Transparency in the Bond Jungle
The reorganization of bonds on the Frankfurt Stock Exchange creates transparency and helps investors find their way through the jungle of bond types. For the first time, all bonds on the Frankfurt Stock Exchange will be divided into 11 categories. Independent of the somewhat incomprehensible names, investors will know exactly in what type of bond they are putting their money.
Depending on the way interest is calculated, bonds are differentiated between no-coupon bonds and bonds with interest coupons.
- Bonds with variable interest rates (floaters)
For this type of bond, the interest rate is set by the issuer after each interest period. The interest is generally derived from certain benchmark rates, usually short-term intrabank rates. Bonds with variable interest rates can take on many forms. There can, however, be upper and lower limits placed on the interest-rate spread. Investors should look closely at how the interest rates are calculated before they invest in floaters.
- Zero coupon bonds (zero bonds)
Investors holding no-coupon bonds don't get fixed interest payments. Instead, no-coupon bonds are issued at prices well below their par value. When they mature, they are paid out at the par value. The profit is derived from the difference of the issue price and the par value, meaning the investor realizes the profit in full at maturity. Zero coupon bonds are categorized under the "other bonds" heading on the Frankfurt Stock Exchange. All other types of bonds have a constant interest rate and constant interest payment during the bond’s maturity. The interest claims are literally attached to the bond with an interest coupon.
- Low-yielding bonds
This type of bond has a low coupon and is thus issued at a price below the nominal value. Investors invest in these bonds primarily for tax reasons.
Bonds can also be sorted according by the type of issuer. There are government and private issuers.
- Federal bonds (Bunds)/government bonds
To finance its capital needs, the Federal Republic of Germany, the federal states, cities and municipalities issue various bonds. The federal government issues government bonds (maturity between 10 and 30 years), German federal medium-term bonds (maturity of about five years) and treasury bonds (maturity of about two years). The respective conditions of these securities serve as important yard sticks for the entire capital market. Immediately following placement, government bonds are introduced to trading on the German capital markets. The bonds are issued, or supplemented, several times a year using a tender process, similar to an auction.
Like the Federal Republic of Germany, other states, municipalities or cities issue bonds to cover their capital needs. Bonds issued by governments within the euro zone are comprised under the heading of euro government bonds. Most euro-zone countries have credit ratings similar to Germany; yields vary only slightly from yields on German government bonds (see yield curves).
- Emerging markets bonds
Emerging markets, or countries that are on the threshold to becoming industrial nations, have a large need for capital. They cover this by issuing bonds in “hard” currencies explicitly from abroad. These countries include Argentina, Brazil, India and China. Emerging-market bonds are primarily denominated in euros and dollars. They are attractive because their issuer pays relatively high interest. The risk in investing in such bonds is that the issuer typically has a lower credit rating because of the difficulty in forecasting economic development.
- Corporate bonds
Companies often take advantage of the opportunity to raise money using corporate bonds instead of bank loans. The bond’s initial coupon or yield, as the case may be, is determined by the company’s credit rating. The worse the rating, the higher the interest or yield. Investors must expect that if a company’s rating changes, the price of the company’s corporate bond will also change. Corporate bonds can react very sensitively to changes in the macroeconomic environment. Unlike German covered bonds, corporate bonds are securitized at a lower priority. That means, if a company can no longer service its debts, other creditors are paid out before the bond holders are.
- Mortgage bonds / Pfandbriefe
Banks issue credit to private and corporate customers. The banks get the required capital by issuing bonds. A particular form of this bank credit is the Pfandbrief (collaterized mortgage bond), which is bound by strict legal regulations covering the use of credit and the issuer’s liability. The money raised can only be used to finance real-estate development. The credits are securitized and the real estate serves as collateral.
- Jumbo covered bonds (Pfandbriefe)/Covered bonds
In the past, covered bonds, known in German as Pfandbriefe, were typically bought by investors and held until they matured. There was no active trading of these absolutely safe investments. In order to promote the trading of covered bonds and to make these investment vehicles attractive for foreign investors, jumbo covered bonds, or jumbos, were introduced in 1997. Several smaller issues were combined to form one large bond called a jumbo. Jumbo covered bonds must fulfill the following criteria: - the issue volume has to be at least 1 billion euros - it can only be divided into tranches of at least 125 million euros - at least five market makers set bid and ask prices simultaneously during normal trading hours of 9am to 5pm with order volumes of up to 15 million Euros.
- Tier 1 bonds
Tier 1 bonds are lower-rated bank bonds. That means, if the issuer defaults, all of the bank’s other creditors must be repaid before the bond investors recoup their money. Tier 1 bonds have unlimited maturity. The issuer pays interest on the bond only when the bank also pays a dividend.
In addition, there are other criteria that differentiate bonds, based on specific characteristics.
- Foreign-currency bonds
This category comprises all bonds that aren’t euro denominated – regardless of whether the issuer is the state or private. The category includes bonds issued in key currencies such as the dollar and pound, but also, for example, the South African area. Issuers can be either governments or private companies. The attraction of bonds denominated in foreign currencies is the potential for higher interest rates and the chance to profit from fluctuating exchange rates. However, there is also a risk of a decline in the exchange rate relative to the euro.
- Participation certificates
Participating bonds aren’t standardized securities; they are a mixture between stocks and bonds. Owners of these securities don’t have voting rights, unlike a shareholder. On the other hand, the bonds collateralize the creditor and their owners are paid interest on their investment at a higher rate than with a normal corporate bond. The interest payments are tied to the company’s performance. Following a profitable year, the payout can be increased; in the worst of times, the payment can be cancelled altogether. For listed companies, the shareholders vote on the amount of the payment at the annual meeting. Because this class of bond isn’t regulated by lawmakers or the exchanges, there are many different types of participating bonds.
- Convertible bonds
Convertible bonds can be issued by publicly listed companies. They are fixed-interest securities that give investors the right to trade for shares or exercise an option on shares. With convertible bonds, the investor can convert the bond into shares in the company during the bond’s maturity. If the conversion rights are exercised, the bond expires. Warrants are interest-bearing securities that give the investor the right to acquire shares or other tradable assets collateralized by the bond’s warrant. Convertible bonds are a cost-effective way for companies to raise money. The issuers lower market-prevailing interest rates that they usually must pay investors. In return, the company sweetens the prospect of lower interest with the right to buy the company’s shares at a previously set price.
- Structured bonds
Structured bonds also belong to the group of fixed-interest bonds. Generally, they function like a normal bond with a fixed interest rate. However, the individual bonds have additional conditions attached. That can affect the interest-rate conditions, i.e., the coupon increases or falls in fixed steps or the bond converts into a floater after a fixed period of time. But special repayment conditions make a fixed-interest security part of the structured bond family, which is the case for credit linked notes. For this form of bond, the issuer collateralizes a credit that he’s issued to third party. If this debtor defaults, the bond owner is liable for the outstanding credit in the amount of the bond. Investors should review very closely the interest and repayment conditions attached to structured bonds.