Navigating different types of bonds: a brief guide

Behind a simple basic mechanism, there are different types of products, with different characteristics and mechanisms. Bonds are securities with which a debtor (the issuer) finances its assets.
types of bonds

Behind a simple basic mechanism, there are different types of products, with different characteristics and mechanisms. Bonds are securities with which a debtor (the issuer) finances its assets. In return, it undertakes to pay interest to the creditor, as well as to repay the entire principal at maturity. Within this general definition, there are different types of bonds. Here are some of the most common.

Ordinary and structured bonds

The first distinction concerns ordinary and structured bonds. Bonds with more classic and straightforward characteristics belong to the first category. It is no coincidence that they are referred to in English as ‘plain vanilla’, precisely to describe their simple, standard operation.

The holder of a plain vanilla bond is entitled to receive full repayment of the principal at maturity, plus periodic remuneration (interest) in the form of a coupon.

Structured bonds, on the other hand, have a more complex functioning, because they incorporate a derivative instrument that determines their characteristics and returns. Structured bonds allow, for example, to exercise an option on the underlying or to have a return linked to the performance of indices and indicators (of markets, currencies, price trends). In cases like this, one also speaks of ‘index-linked bonds’.

Fixed and floating rate bonds

Ordinary bonds can be grouped into two macro-categories: fixed-rate and variable-rate. In both cases, the holder receives the invested capital at maturity. What distinguishes them is the mechanism by which the interest is defined. In fixed-rate bonds, they are predetermined. Whoever buys them knows in advance that, for example, he will always receive interest of 4% per annum.

In variable-rate ones, on the other hand, the remuneration depends on market rates. The issuer, therefore, does not have to specify the size of the coupon but only how it will be calculated. The interest rate may, for example, be pegged to the inflation rate. The more prices rise, the more substantial the coupon will be.

Fixed-rate bonds certainly have the advantage of being predictable and immediately understandable. Net of risk, it is possible to know how much you will earn and how often. Variable-rate bonds, on the other hand, allow you to better manage market changes and their value is less volatile.

They are less dependent on reference rates and, consequently, give the financial portfolio more stability. However, if central bank rates fall, they will tend to offer a lower yield than fixed-rate bonds.

Subordinated bonds

In addition to being used to mark the difference with structured bonds, the term ‘ordinary bonds‘ can refer to the rights acquired by the creditor, which are prioritised.

There are, in fact, also subordinated ones, which – in the event of financial difficulties of the issuer – must wait for coupons and redemptions to be paid first to holders of ordinary bonds. In ‘exchange’ for this risk, subordinated bonds should have a higher yield.

Zero-coupon bonds

Not all bonds have a coupon. This is the case with zero-coupon bonds, such as BOTs and CTZs, whose yield is determined by the difference between the issue price and the redemption value.

To trigger this mechanism, zero-coupon bonds are issued at a lower price than the nominal price, which will instead be repaid at maturity.

Convertible bonds

Convertible ones can be defined as a middle ground between bonds and shares. They offer the holder, within a fixed time horizon, the possibility of deciding whether to convert the bond into shares.

In essence, one can choose whether to remain a creditor – receiving repayment at maturity – or become a shareholder of the issuer.

Eurobond

Eurobonds are securities involving several states, for which the country of the issuer is different from the country of placement. These products have been in operation for decades.

The word Eurobond, however, is likely to cause confusion, because it also indicates a mechanism that has long been proposed but never materialised: the possibility of issuing European bonds guaranteed jointly and severally by all member states.

Read also: Green bonds: what they are and how do they work

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