Classification of Fixed Income Securities Based on Coupon Rate
The interest rate promised per the bond’s contract is a coupon. Bond coupon payments can be payable yearly, semi-annually, quarterly, monthly, or upon maturity. First, let’s have a look at different types of bonds based on coupons:
Plain Vanilla Bonds
Plain Vanilla Bonds are the most basic type of bonds. They have a fixed interest rate paid at predetermined intervals and have pre-determined maturity. Also, the face value of these bonds is predetermined. So the investor receives the bond at face value when it matures. For example- the redemption date for a bond is 10 years from the date of issuance, and the interest rate is 5%. So the bondholder will earn 5% x ₹1000 (face value)= ₹50 every year for the next 10 years.
Zero Coupon Bonds
It is a discounted instrument that does not pay any interest and is redeemed at face value of the bond when it matures. As an investor, you must wonder, “then how is it profitable?” Zero Coupon Bonds are discounted bonds that are repaid at face value, and the investors earn the difference amount. Suppose a zero-coupon bond with a face value of ₹20,000 maturing in 20 years with an interest rate of 5.5% can be issued for ₹7,000. When the bond matures after 20 years, the investor will get a lump-sum amount of ₹20,000, which is a return of ₹13,000. These bonds have a single cash flow when it matures, which is the face value of the bond. Some examples of Zero Coupon Bonds in India include Treasury Bills, Cash Management Bills and STRIPS. You have to keep in mind that these bonds are very sensitive to changes in the rate of interest because they do not have intervening cash flows and are used mainly by long-term fixed-income investors, including pension funds and insurance companies, to measure and balance the interest rate risk of these company’s long term liabilities.
Floating Rate Bonds
These are the debt instruments that do not have a fixed interest rate and the interest rate fluctuates depending on the benchmark it is drawn. For instance, repo rate or reverse repo rate can be set as benchmarks for floating rate bonds. Let’s say, the rate of interest for floating rate bond is 35 basis points over and above National Saving Certificate (NSC) rates. The change in interest rate is adjusted as 35 basis points over the current NSC rate. Say the current NSC rate is 6.8%, so the interest rate on floating rate bonds will be 6.8% + 0.35%= 7.15%.
Caps and Floor
Bond issuers issue bonds that cap their interest payment obligation in case the interest rate rises. At the same time, these instruments also provide a floor beyond which the interest rate does not fall. A cap limits the interest a bond issuer pays when the interest rate rises as it fixes a maximum level of return for the investor. On the other hand, a floor sets a minimum interest that a borrower pays and sets a minimum interest that can be expected by the investor.
It is a type of bond where the interest rate has an inverse relationship to the benchmark rate. These bonds adjust their coupon payments with the change in interest rates. Typically, these bonds are issued by governments or corporations.
Inflation Indexed Bonds
As the name suggests, these bonds protect investors from the effects of inflation. The rate of interest in these bonds is linked to an index like Consumer Price Index (CPI) and is not volatile in nature. The minimum investment for individual investors is Rs 5,000 and a maximum of Rs. 10 lahks per year; for institutional investors, the maximum limit is Rs. 25 lakhs.
Step-up Bonds are made to pay lower coupons in the initial few years and higher coupons in the last few years before it matures. Typically, these bonds are issued by start-ups who expect their cash flow to increase in the coming years. Therefore, these bonds come with a higher risk for the investors since the cash flow is expected after some time and to compensate for the chance, it comes with a higher interest rate to make them more attractive.
Step-down bonds are the exact opposite of step-up bonds. Step-down bonds pay higher interest in the beginning years, and the coupon drops as the bond matures. The companies issue these bonds when there is a decline in revenue expected which may be because of wear and tear of assets and machinery. Both the step-up/down bonds are used for planning better cash flow for issuers and investors.
Deferred Coupon Bonds
It is a debt instrument that pays all of its interest in a single payment made at the end and not in pre-determined intervals. An example of deferred coupon bonds can be zero coupon bonds that do not pay any interest but offer appreciation in the bond value at maturity.
Deep Discount Bonds
These bonds are sold at a lesser value than their face value. Generally, it offers a discount of 20% or more with a more extended maturity period. Infrastructure companies issue these bonds since their gestation period is very long, and these bonds carry high risks.
Frequently Asked Questions (FAQs)
Why invest in fixed-income securities?
Fixed-income securities provide a reliable cash stream, and a diversified portfolio can provide a decent return with less volatility.
What are Coupon payments in fixed-income securities?
Coupon payments are the cash flow offered by the issuer at fixed intervals. It is expressed as a percentage of the face value of the bond.
What is maturity?
Maturity is the period during which a bondholder will receive interest payments on the investment. When the bond reaches maturity, a bondholder is repaid its par, or face, value.