Bonds are one of the three major asset classes in the market. Bonds are important to an investment portfolio because they help diversify your portfolio, provide stability to it, and act as a source of secondary income. Understanding the different types of bonds in the market will help you make informed decisions which will help boost your portfolio returns.
Types of Bonds
There are different types of bonds in the Indian market, and they can be broadly classified into ten categories based on different classification factors. The ten classification factors are as follows:
- Issuer
- Security
- Seniority
- Interest rate
- Maturity
- Listing
- Convertibility
- Credit rating
- Taxability
- Embedded option
Types of Bonds Based on the Issuer
There are two types of bonds based on the issuer: government and corporate.
Government Bonds
These bonds are issued by the central and state governments and are considered extremely safe. Hence, they are also known as ‘risk-free’ bonds and ‘sovereign bonds’. This is because they are backed by the government, which has the highest credibility among investors.
Corporate Bonds
Bonds issued by companies, both public and private sector, are corporate bonds. They are considered riskier than government bonds as the company can pay investors like you only if they generate revenue and profits. Since revenue generation depends on multiple factors, both internal and external, there is no guarantee that the corporations will pay the principal and interest. However, bonds issued by public sector companies are slightly less risky than bonds issued by private sector companies. This is because public sector companies are backed by the government.
Types of Bonds Based on Security
Under this category, bonds are categorised as secured and unsecured bonds.
Secured Bonds
Secured bonds are bonds which are backed by a specific asset which the bond issuer owns. As an investor of the bond, you can use this asset as a resort in case the bond issuer defaults on the payment. Companies that issue secured bonds usually use their machinery, factories, or even shares as a guarantee to issue bonds. In case of non banking financing companies (NBFCs), the bonds are secured by loan receivables. Bonds that are backed by real estate are known as mortgage-backed securities. Private companies and public sector undertakings can issue secured bonds.
Having a security backing a bond doesn’t make it less risky. However, they are considerably safer when compared to bonds that are not backed with an asset. So, if the company defaults on the payment, you as an investor have a legal right to get back your money when the collateral is liquidated.
Unsecured Bonds
Unsecured bonds are bonds that are not backed by any asset. When the government issues bonds, it has a sovereign credit rating. This increases the investor’s confidence, and hence, unsecured government bonds are considered risk-free.
When corporations issue unsecured bonds,there is no guarantee that you will receive your principal and interest payments in case of a default, as these bonds are not backed by any asset. Hence, unsecured corporate bonds are considered very risky. However, if these bonds are issued by companies with a very good credit rating and have an excellent track record, they are considered low-risk investments.
Types of Bonds Based on Seniority
Bonds are ranked based on their seniority, and the most senior bonds are stacked at the top of the capital structure. It is the bond seniority that determines which bond will be paid first in case of bankruptcy. Based on seniority, bonds are categorised as senior secured, senior unsecured, and subordinate bonds. The preference shareholders and equity shareholders are paid the last.
Senior Secured Bonds
These bonds are ranked at the top of the capital structure and, hence, will be paid first if the company plans to dissolve itself or goes bankrupt. These bonds usually have the lowest interest rate compared to bonds of other levels of seniority.
Senior Unsecured Bonds
These bonds rank just below the senior secured bonds and fall second in line in terms of payment when a company goes bankrupt. The interest rate on these bonds is slightly higher than senior secured bonds.
Subordinate Bonds
Bonds that rank the lowest in the capital structure are called subordinate bonds. They will get paid after the senior bonds are paid off. These bonds have the highest interest rate among all the three types of bonds in this category. Subordinate bonds have different tiers, namely Tier 1, Tier 2, and Tier 3. Each tier has different ranks of seniority. Tier 1 ranks highest in terms of seniority; Tier 2 comes next, and then Tier 3. The lower the rank, the higher the interest rate.
Types of Bonds Based on Type of Interest Rate
Bond issuers pay interest on the face value of the bond. Based on the type of interest rate, the bonds can be categorised into three types, namely fixed, floating, and zero coupon bonds.
Fixed Interest Rate Bonds
These bonds pay a consistent interest until maturity, and hence, you can earn predictable returns.
Floating Interest Rate Bonds
The interest on floating bonds keeps fluctuating throughout the tenure of the bond. This is because the interest is linked to a market benchmark such as the 91-day or 182-day treasury bills. These bonds are issued at a spread say 1-2% to the benchmark interest rate. The interest rates on these bonds get revised at every periodic interval such as quarterly or semi-annually.
Zero Coupon Bonds
As the name suggests, zero-coupon bonds do not pay any interest or coupon. Instead, they issue the bond at a discount and repay the face value to you on maturity. The difference between the discounted price and the face value is your yield or return.
Types of Bonds Based on Listing
Based on whether bonds trade on the stock exchange, they are classified into the following categories.
Listed Bonds
Bonds that trade on the stock exchange are known as listed bonds. In India, bonds are either listed on the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE) or both. Hence, you can buy and sell bonds from the secondary market.
Unlisted Bonds
Bonds that are not listed on the stock exchange are known as unlisted bonds. You can trade in these bonds through the over-the-counter (OTC) market.
Types of Bonds Based on Convertibility
Although bonds are considered low-risk investments, stocks have the potential to deliver higher returns. Hence, companies sometimes issue bonds with the convertibility feature, where you can convert bonds into shares. Bonds can be converted only if certain conditions are met or a certain time duration is completed. Based on the convertibility, bonds can be classified into the following categories.
Fully Convertible Bonds
Fully convertible bonds can be fully converted into shares after a certain point in time. Once the conversion is complete, you will become a shareholder of the company instead of a bondholder.
Partially Convertible Bonds
Partially convertible bonds can be converted into shares, but not fully. After the conversion is complete, you will become a shareholder but will still hold some bonds.
Non-Convertible Bonds
Non-convertible bonds cannot be converted into shares at any point in time.
Types of Bonds Based on Credit Rating
Bonds are rated by credit rating agencies. The credit rating of a bond indicates the bond issuer’s ability to repay its liabilities. The higher the credit rating, the lower the probability of a default. There are fourteen levels of credit rating, starting from AAA, AA and all the way up to D. Based on credit rating, bonds are categorized into investment grade or non investment grade bonds.
Investment Grade Bonds
Bonds rated BBB- or better are known as investment grade bonds. They have lower yields due to their low risk. Companies issuing these bonds are usually well established, and financially sound. Hence the risk of default is low.
Non-Investment Grade Bonds
Non-investment grade bonds are also known as junk bonds. They are financial instruments having a credit rating below BBB-. These bonds are riskier than investment grade bonds but have higher yields. The higher interest rate compensates for the high risk of these bonds.
Types of Bonds Based on Taxability
Based on taxability, there are two kinds of bonds, namely tax-free bonds and tax-saving bonds.
Tax-Free Bonds
These bonds are like any other bond where you can earn interest over the term of the bond, and the principal is repaid at the time of maturity. However, the interest earned is exempted from tax under these kinds of bonds.
Tax Saving Bonds
Tax-saving bonds are bonds where the initial investment in bonds is exempted from tax. The interest is, however, taxable, and there is also a lock-in period during which you cannot redeem your investments.
Types of Bonds Based on Embedded Option
An embedded option represents the right the bondholder or the issuer can exercise depending on the course of the interest rates. There are two types of bonds based on the embedded options, namely callable and puttable bonds.
Callable Bonds
Callable bonds give the right to the issuer to call back bonds at a predetermined price and date. These bonds usually pay higher interest than other kinds of bonds as the bond issuer has the benefit of calling it back.
Puttable Bonds
Puttable bonds give you the right as an investor to ask for repayment at a predetermined price and date (which is before the maturity date). These bonds usually pay a lower interest as you (the investor) has the benefit.
Final Word
In conclusion, a comprehensive understanding of bonds and their types is necessary for constructing a well-balanced portfolio. Each bond category has a distinctive risk-reward offering, catering to various investor preferences.
Government bonds are known for their stability and safety. On the other hand, corporate bonds have the potential to generate higher returns. Convertible bonds present a unique blend of equity and fixed-income features, while, inflation-indexed bonds act as a safeguard against rising prices.
Thus, based on your risk tolerance level and investment goals, it’s prudent to pick the bond that aligns with your needs. Alternatively, you can speak to us, and we can help you pick the right investment based on your preferences and profile.
Frequently Asked Questions
What is a bond and its types?
A bond is a fixed-income instrument that allows companies and governments to borrow money from the public. They, in turn, pay interest to the investors for a predetermined period of time.
How do you classify bond types?
Bonds can be classified based on the type of issuer, security, maturity, interest rate, convertibility, credit rating, and listing.
Which bonds are the most risky?
Bonds with higher interest rates are considered very risky as the borrower pays a high-interest rate to compensate for the low creditworthiness.
Are bonds low risk?
Bonds are considered low-risk investments when compared to equity. This is because they pay a fixed interest to the investors, unlike equity, where the returns are volatile and unpredictable.
Is bond a loan?
Bonds are debt instruments that companies use to raise money in exchange for a fixed interest payment. Since the bondholders do not get a stake in the company and get fixed payments, bonds are a type of loan.
Are bonds and debentures the same?
Bonds and debentures are used interchangeably in the debt market. However, there is a small difference between the two. Bonds are debt instruments that are backed by collateral and hence are considered safe. Debentures, on the other hand, are not backed by any physical asset or collateral making them slightly risky than bonds.
