Bond features differ from bond to bond. These features ultimately affect the risk and return we get when we buy bonds. For example, we differentiate bonds based on their issuer, which can come from corporations, governments, or supranational institutions. Government bonds have a lower risk than corporate bonds.
Another feature is the issuer’s credit rating and maturity. If it has a low credit rating, the issuer is more at risk in paying obligations (coupon and principal). But, they come with higher returns to compensate for the higher risk.
Likewise, bonds with longer maturities are riskier than those with shorter maturities. When maturities are longer, there is higher uncertainty regarding coupon and principal payments. In contrast, the uncertainty is lower when bonds mature in shorter terms.
What are the other bond features? This article will briefly discuss the following points:
- Bond issuer
- Maturity date
- Face value
- Coupon rate
- Bond currency
- Credit rating
- Embedded provision
Who are the bond issuers? They can be corporations, governments, or supranational organizations. For example, a company issues bonds to raise funds to finance expansion. And issuing bonds is an alternative to issuing shares.
For companies, issuing bonds may be the preferred alternative to taking out a bank loan. That’s because bonds are usually considered cheaper than bank loans.
Meanwhile, supranational bonds come from organizations such as the International Monetary Fund (IMF) and the World Bank. They issue bonds to finance their program. For example, in 2021, the World Bank issued bonds worth GBP1 billion with a tenor of 7 years and maturing in July 2028. The issuance is to finance sustainable development activities.
Government bonds are lower risk than corporate bonds. Therefore, sovereign bonds usually have a higher rating than corporate ratings, except in special cases. For this reason, investors demand a higher premium when they buy corporate bonds to compensate for the higher risk.
Credit ratings are a key bond feature besides face value and coupons. It varies between bonds, depending on the issuer’s creditworthiness.
Creditworthiness shows how able and willing the issuer is to pay its obligations, namely paying regular coupons and principals at maturity. When they cannot meet their obligations, they default.
The default rate is positively related to the coupon rate. The higher the default risk, the higher the coupon rate paid. Investors perceive them as riskier, so they demand higher coupons. For issuers, higher coupons make funding through bonds more expensive.
Creditworthiness is indicated by the rating given by the credit rating agency. Standard and Poor’s (S&P), Moody’s, and Fitch are the three largest global credit rating agencies. And they give a rating from very good to worst, which in order are: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB-, B +, B, B -, CCC +, CCC, CCC-, CC +, CC, CC-, C +, C, C- and D.
Please note Moody’s and other credit rating agencies may use a different notation than the above, even though it is conceptually the same. For example, the highest rating of AAA equals Aaa by Moody’s. The rating indicates the issuer has the lowest default risk relative to other ratings.
Then, we categorize bonds based on these ratings into two groups:
- Investment grade
- Non-investment grade
The investment grade has a BBB- rating or higher (equivalent to Baa3 or higher by Moody’s). In addition, these bonds have relatively low default risk. Thus, they offer relatively low returns.
Non-investment grade is rated lower than BBB- (equivalent to below Baa3 by Moody’s). And they have high yields because they are riskier than investment-grade bonds. Therefore, we also refer to them as high-yield bonds. Other names are speculative bonds and junk bonds.
The maturity date is the next bond feature. It refers to the date on which the issuer will repay the principal. The period between the issue date and the maturity date is what we call the tenor.
Bonds come with various tenors; there are 3 years, 3 years, and up to more than 10 years. Specifically, we name them differently. If they mature in less than 1 year, we call them bills. If the maturity is 10 years or less, we call them notes. And if the maturity is more than 10 years, we call it a bond.
The longer the tenor, the riskier it is. Longer tenors carry more uncertainty regarding coupon and principal payments. Therefore, they will offer a higher return rate to compensate for the higher risk. We get a yield curve if we plot the relationship between maturity and yield.
Although bonds generally have a maturity date, specific cases may not exist. We call them perpetual bonds. The issuer will not have to redeem the principal but perpetually pay the coupon.
Normal yield curve and inverted yield curve
In a normal yield curve, a higher tenor offers a higher yield and vice versa. But, in special cases, it can be inverted where longer tenor bonds have lower yields than shorter tenors. That we call the inverted yield curve.
Yields are inversely related to bond prices. The yield falls when the price goes up, and vice versa. Rising prices allow us to earn capital gains when selling bonds.
In addition, bond prices are sensitive to market interest rates. An increase in market interest rates causes bond prices to fall, and therefore, yields rise. Conversely, a decline in market interest rates pushes prices up and yields down.
Nominal value (par value or face value) refers to the principal amount the issuer will pay on the maturity date. Typically, bond prices are quoted as a percentage of their face value. For example, suppose a bond is quoted at 95. Say it has a face value of $1,000. Quote 95 shows the bond’s current price is $950 (95% × $1,000).
Quotes make it easy for us whether a bond trades at a premium, discount, or par. The bond is at a premium when the price is above 100%. Meanwhile, the 100% quote shows the bonds are traded at par (at par). Lastly, the bond is at a discount if it is below 100%.
At maturity, the bond price always points to its face value (100%). So, bond prices tend to fall closer to their maturity date when trading at a premium. In contrast, a discount bond will see a price increase nearer the maturity date.
A coupon refers to the nominal interest paid by the issuer to the bondholders. If we divide it by the face value, we get the coupon rate expressed as a percentage. It is similar to the interest rate on a bank loan, which represents a percentage, and interest represents the value.
For example, a $100 bond with a coupon rate of 6%. The issuer regularly pays bondholders $6 (100 x 6%) coupons.
The issuer pays the coupon periodically until maturity. Payments can be annual, semi-annual, quarterly, or monthly. So when the bond payments in the example above are quarterly, the bondholder will receive a coupon of $1.5 ($6/4) every three months.
Fixed-rate bonds vs. floating-rate bonds
The coupon feature distinguishes bonds into two categories:
- Fixed-rate bonds
- Floating-rate bonds
Fixed-rate bonds pay a fixed coupon rate from the first issue to maturity. For example, a company issues bonds and offers a coupon rate of 6% yearly, paid semiannually. Say the bond has a nominal value of $100. Thus, the company will pay a coupon rate of 3% per semester or $3. The coupon percentage did not change even though market interest and inflation rates changed.
Meanwhile, floating-rate bonds offer variable coupons. The percentage changes from time to time. For example, the coupon rate formula is 2% + Reference interest rate. Let’s say the three-month London Interbank Offered Rate (LIBOR) is the reference rate. Then the coupon rate is 2% + 3 months LIBOR. When LIBOR changes, the coupon rate also changes.
Floating-rate bonds may use the inflation rate as a reference. An example is Treasury Inflation-Protected Security (TIPS). TIPS protects investors from inflation. As a result, the nominal value will increase during inflation and decrease during deflation.
In addition to these two types, there are also zero-coupon bonds. In this case, the issuer does not pay for the coupon at all. Instead, they sell it at a discount to attract investors. And because it’s sold at a discount, its price will slowly rise until it’s near maturity, and investors get a capital gain when selling it.
Bonds come in different currency denominations. Generally, issuers issue local currency bonds if their target is local investors. These bonds have no translation risk because investors and bond issuers use local currency in their operations – unless the investor is a foreign investor.
However, a less liquid market may make local currency bonds relatively less attractive to foreign investors. In addition to liquidity risk, foreign investors must bear translation risk from investing in a currency different from their operating currency.
To reach more investors, issuers may issue their bonds in international markets. Their bonds are denominated in international currencies such as US dollars and Euros. We call them global bonds.
When issuing global bonds, issuers potentially attract more demand from global investors. However, it comes not without risk. They also bear translation risk when their local exchange rate fluctuates against the US dollar or Euro.
When it comes to global bonds, there are a few names you may have heard of:
- Samurai bonds – yen-denominated bonds issued in Japan by non-Japanese issuers. They are subject to typical Japanese regulations. For example, an Indonesian company issues yen bonds in Tokyo.
- Eurobonds – bonds issued in a currency other than the local currency in the market in which it is issued. For example, an Indonesian company issues rupiah-denominated debt securities in the United States.
- Euroyen – yen-denominated bonds issued outside the Japanese market and the issuer’s local market. In other words, they are Eurobonds issued in Japanese yen. For example, an Indonesian company issues yen-denominated bonds in the United States.
- Eurodollars – Eurobonds issued in US dollars outside the American market and the issuer’s local market. For example, an Indonesian company issues US dollar-denominated bonds in Japan.
The translation effect can be positive or negative. For example, when issuers’ local currency depreciates against the US dollar, issuers have to bear a higher debt burden. This is because they must collect more local currency and convert it into US dollars to redeem the bonds.
Take a simplified example. An Indonesian company issues $1 global bonds when the exchange rate of the rupiah against the US dollar is equal to IDR14,000 per US dollar. When the rupiah depreciates to IDR28,000, the company must raise more (IDR28,000) to get $1 and redeem the bonds.
On the other hand, appreciation lowers the debt burden. This is because the issuer collects less local currency to convert it to US dollars, making redemptions cheaper.
Translation risk also applies to investors. For example, when foreign investors buy rupiah bonds, they must exchange US dollars for rupiah. Suppose the rupiah depreciates against the US dollar. In that case, they can get more for the same dollar amount, allowing them to buy more rupiah bonds. For example, the rupiah exchange rate is IDR14,000 per US dollar. By investing $1, they can buy 14,000 rupiah bonds. If it depreciates to IDR28,000, they get 28,000 rupiah bonds for every $1 invested.
However, when realizing gains, depreciation makes returns in dollars less. This is because they get their returns in rupiah, and as they depreciate, they will get fewer dollar returns. For example, when they exchange an IDR28,000 return, they get 1 US dollar. On the other hand, if the rupiah is still at IDR14,000 per US dollar, they get $2.
Then, if the rupiah appreciates, foreign investors must invest more US dollars to buy rupiah bonds at the same nominal value. However, when they realize a return from rupiah to US dollars, the appreciation allows them to earn more dollars.
Some bonds also include an embedded provision. This bond feature gives the holder or issuer the right to take certain actions. They include callable, puttable, and convertible features.
The putable feature gives the bondholder the right to sell ownership to the issuer before the maturity date at a certain price. The puttable feature allows us to reduce our risk exposure when bond prices fall. For example, we activate the puttable option when the market interest rate rises. An increase in interest rates pushes prices down. So by selling them early, we limit our risk as bond prices may fall further. Then, we can reinvest the proceeds to buy other, more attractive bonds.
Callable features are the opposite of putable features. Callable bonds give the issuer the right to buy back the bonds from the bondholders before the maturity date at a specified price. For example, issuers usually call bonds when market interest rates fall. By redeeming early, they can reissue other bonds at lower interest rates.
The next embedded provision is conversion. Convertible bonds are hybrid securities that offer bondholders the right to convert the bonds into several common shares before the bond’s maturity date. After conversion, bondholders are no longer entitled to coupons. Instead, they are entitled to dividends distributed for being shareholders.
Seniority is related to rank in the payment order. Therefore, senior bonds have a higher priority for receiving payments than junior bonds.
As we know, some bonds offer collateral to bondholders while others do not. The collateral may be a tangible asset, such as property, plant, or equipment.
Based on this factor, there are two types of bonds:
- Secured bonds
- Unsecured bonds
Under secured bonds, bondholders are legally entitled to seize the assets pledged when a default occurs. In addition, they can sell the collateral to recover their investment. On the other hand, such a feature does not exist in unsecured bonds.
Thus, secured bonds are safer than unsecured bonds. For this reason, bondholders demand a higher coupon rate to compensate for the higher risk on unsecured bonds.
Then, in particular, some unsecured bonds have a lower priority than other unsecured bonds. Lower priority unsecured bonds are referred to as subordinated bonds, which receive payment only after the higher priority claims are settled. Furthermore, subordinated bonds can also be sorted by priority, from senior to junior.
What to read next
- Bonds: Types, Features, Risk, Pros and Cons to Investing In It
- Complete Bond Features. What You Need To Know.
- Bond Issuers: Who Are They?