In times of market volatility and economic uncertainty, investors prefer to stay away from risky assets such as equities and commodities. Instead, they flock towards low yielding but safer instruments such as government bonds and treasuries. Three factors mainly classify a bond. The Variability of Coupon, Variability of Maturity and Principal Repayment. Let us understand them in detail.
Variability of Coupon
There are mainly three types of coupons:
- Zero Coupon Bonds: A buyer can buy these bonds which are less than the face value. When the bonds mature, the holder gets the actual face value. The holder does not get any interest on these bonds. The maturity period increases if the buying price is much lower.
- Treasury Strips: A government broking firm trades their treasury bonds and uses that money to issue zero coupon bonds. The firm then sells these bonds with varying maturities to the secondary market and earns from that transaction. This practice is popular mainly in the US.
- Floating Rate Bonds: Floating rate bonds come with coupon rates that are not fixed. The coupon rates vary from the face value. The rate of a floating rate bond may change even during an ongoing maturity period. The holders learn about the rates and act accordingly.
Variability of Maturity
There are two types of actions that can be taken on the maturity period:
- Callable Bonds: For a callable bond, the issuer of that bond can change the maturity period of the bond if required. These bonds have this option from the time of issue and the change can be made anytime before the maturity. This feature can benefit a holder if the interest rates are rising.
- Puttable Bonds: With this option, a holder can sell his bonds anytime before the maturity. If the interest rates are rising, the holder can sell the bonds with the low rate and buy the bond with the higher rate. These bonds are therefore more risky for the issuer.
Principal Repayment
There are two types of bonds depending on the principal repayment:
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Amortizing Bonds: In this repayment system, the issuer repays the holder over the entire maturity period of the bond. The last payment is done on the maturity date.
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Sinking Fund Provisions: Sinking Fund Provisions is the system where the issuer pays part of the repayment amount every year to the holder.