Bonds: types and features techyadjectives

Posted on

Types of securities

There is a wide variety of different instruments on the financial market that can bring investors one or another profitability, depending on the type, term and degree of risk.

On the money market (a part of the financial market), the participants (creditors and borrowers) of which are mainly credit institutions, NPOs and legal entities, instruments with a maturity of up to 1 year are placed:

  • treasury, commercial,
  • bank bills,
  • certificates of deposit (for legal entities),
  • commercial paper,
  • savings certificates (for individuals),
  • short-term loans (interbank, commercial).
  • These are all short-term securities.

They are mainly used by banks and enterprises to obtain short-term liquidity for certain purposes (pay off accounts payable, replenish working capital, etc.). Investors consider them to be relatively liquid short-term investments that, under normal circumstances, may carry little inflation or credit risk.

Long-term securities

The second block of the financial market, where instruments with a maturity of 1 year or more are traded, is called the capital market. Debt securities with such a maturity period are usually called bonds, from lat. obligatio – “obligation”. The issuer undertakes to pay the lender the face value of the bond. In addition, the bond may provide for the right to receive interest for the use of the creditor’s money.

This type of securities can be issued by governments, corporations or other legal entities and serve as a source of medium or long-term financing.

Features of the issue of securities in Russia

In Russia, as a rule, medium-term instruments include securities with maturity in 1-5 years, long-term instruments – more than 5 years. In the rest of the world, these terms are longer (5-10 years for medium-term and 10 years or more for long-term). The difference in terms is due to the development of the economy of a particular country and, accordingly, the volume of the capital market. Developed countries have more sustainable economic models that require longer-term and larger amounts of money than developing countries, for example, oriented towards a volatile commodity model.

Call and put options

It is also worth mentioning such an option as early redemption. What it is? For example, a paper has a maturity of 5 years, but the issuer has the right / obligation to redeem its debt ahead of schedule in 3 years.

Bonds with early redemption are divided into two types:

  • Callable bonds (call option built in). The borrower (issuer) has the right to redeem its bonds ahead of schedule. This feature can be enabled for various reasons. For example, an issuer, forecasting the economic cycle in his country/industry, expects borrowing rates to fall in 3 years, so it makes sense to buy back your debt ahead of schedule and issue new bonds with a lower rate.
  • Bonds with early redemption (embedded put option). The lender (investor) has the right to early redemption of the bonds, and the borrower is obliged to redeem them at a predetermined price. This gives the investor the opportunity to present securities before maturity if there are more interesting/profitable offers on the market.

Call option bonds are predominantly common in advanced economies because business cycles are more predictable and resilient. Accordingly, put option bonds are common in developing countries where rates are more volatile.

Types of bonds by type of issuer

Bonds can be divided into 3 large groups:

  • Treasury bonds. Issued by the Ministry of Finance of a particular country. In Russia, they are called OFZ – federal loan bonds. Bonds of this rank are considered the most reliable, because. The “respondent” for the debt is the country itself.
  • municipal bonds. Comparable to treasury, but issued by some administrative entity, such as a region or state. They have state status, but are associated with the risks of a separate area.
  • Corporate bonds and various asset-backed/non-asset-backed securities. In addition to the risks of the country, these securities are also associated with the risks of the company that issued them. As a rule, they bring higher returns.

Bond payments

Bonds often (but not always) promise regular scheduled interest payments in addition to paying off the principal at maturity. This coupon income may be paid annually, semi-annually, quarterly or at some other interval.

Coupon income can be calculated at a fixed rate or at a floating rate, which is determined for each period with reference to certain published market rates. For example, an OFZ coupon is pegged to the RUONIA interbank lending rate.

There are also discount bonds that do not provide for the payment of a coupon on a permanent basis, but are placed at a price below par.

Less common are bonds with a deferred coupon payment (for example, the debt was taken to take over a company) or with an accruing coupon, which is similar to a bank deposit.

Also, as a rule, in the format of treasury bonds or bonds of large state corporations / development institutions, debts linked to inflation are placed. This is done in order to level out possible fluctuations in inflation when paying subsequent coupons, in a word, so as not to overpay for the debt. Unlike bank deposits, a bond coupon accumulates daily (ACI – accumulated coupon income), i.е. with price stability, the investor can fix additional income at any time, without waiting for repayment.

In Russia, the so-called vanilla bonds are the most popular. the simplest, like vanilla ice cream, bonds with a fixed maturity and a fixed coupon.

Types of bonds by security

By security, bonds can be divided into 3 large groups:

  • Secured bonds

    This type of status is in first place among corporate bonds, since in the event of a company’s bankruptcy, the payment on the debt can be partially repaid through the sale of collateral. Entire enterprises, equipment, securities of a subsidiary, etc. can be pledged as collateral. For banks, these can be bonds secured by a pool of mortgage loans (mortgage bonds) or assets (ABS – Asset backed securities), payments for which are guaranteed by payments on loans, issued by the bank.
  • Unsecured bonds
    This type of bond is the most common and the second most risky, but this does not mean that it has an average risk status. These bonds are usually issued by companies that have sufficient cash flows to service their debt, but do not have a significant cash reserve to carry out any long-term major project to develop their business. Or it can be banks that use these bonds for their core business – lending to companies and individuals.
  • Subordinated bonds

    Bonds with this status are also unsecured and are mostly issued by banks. In bankruptcy, they are in the penultimate place before the shareholders in terms of debt repayment, i.e. have a relatively high risk, for which they pay an additional premium (higher coupon) than older debts. Banks use this type of bonds to pump up capital at various levels in order to comply with the standards set by the regulator. Under certain conditions, these bonds can be written off.

The so-called. “Perpetual” bonds (nominally but not actually) that have a built-in call option, that is, in theory, the bank may not redeem its debt in advance if economic conditions are unfavorable or capital adequacy does not allow it.

Leave a Reply

Your email address will not be published.