Bonds are broadly classified into Three categories they are;
- Classification on the basis of Variability of Coupon
- Classification on the Basis of Variability of Maturity
- Classification on the basis of Principal Repayment
Classification on the basis of Variability of Coupon
a. Zero Coupon Bonds
Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity, the principal/face value is pay back to the holders. No interest (coupon) is paid to the holders and so, there are no cash inflows in zero coupon bonds. The distinction between issue price (discounted price) and redeemable price (face value) itself acts as interest to holders. The issue price of Zero Coupon Bonds is inversely related to their maturity period, i.e. longer the maturity period smaller would be the issue price and vice-versa. These kinds of bonds are also known as Deep Discount Bonds.
b. Treasury Strips
Treasury strips are more popular in the United States and not yet available in India, it is also known as Separate Trading of Registered Interest and Principal Securities, government dealer firms in the United States purchase coupon paying treasury bonds and use these cash flows to further create zero coupon bonds. Dealer firms then sell these zero coupon bonds, all having a different maturity period, in the secondary market.
c. Floating Rate Bonds
In several bonds, fixed coupon rate to be provided to the holders is not specified. Instead, the coupon rate keeps variable from time to time, with reference to a benchmark rate. Such kinds of bonds are referred to as Floating Rate Bonds.
Classification on the Basis of Variability of Maturity
a. Callable Bonds
The issuer of a callable bond has the right (but not the obligation) to modify the tenor of a bond (call option). The issuer may redeem a bond completely or partially before the actual maturity date. These options are there in the bond from the time of original bond issue and are known as embedded options.
This embedded option helps issuer to decrease the costs when interest rates are falling, and when the interest rates are rising it is helpful for the holders.
b. Puttable Bonds
The holder of a puttable bond has the right (but not an obligation) to seek redemption (sell) from the issuer at every time before the maturity date. The holder may work out put option in part or in full. In riding interest rate scenario, the bond holder may sell a bond with low coupon rate and switch over to a bond that offers advanced coupon rate. Consequently, the issuer will have to resell these bonds at lesser prices to investors. So, an increase in the interest rates poses additional risk to the issuer of bonds with put option (which are redeemed at par) as he will have to lower the re-issue price of the bond to attract investors.
c. Convertible Bonds
The holder of a convertible bond has the choice to convert the bond into equity (in the same value as of the bond) of the issuing firm (borrowing firm) on pre-specified terms. This results in an automatic redemption of the bond previous to the maturity date. The conversion ratio (number of equity of shares in lieu of a convertible bond) and the conversion price (determined at the time of conversion) are pre-specified at the moment of bonds issue. Convertible bonds may be completely or partly convertible. For the part of the convertible bond which is redeemed, the investor obtains equity shares and the non-converted part remains as a bond.
Classification on the basis of Principal Repayment
a. Amortizing Bonds
Amortizing Bonds are those types of bonds in which the borrower (issuer) pay back the principal along with the coupon over the life of the bond. The amortizing schedule (repayment of principal) is prepared in such a way that whole of the principle is repaid by the maturity date of the bond and the last payment is done on the maturity date. For example - auto loans, home loans, consumer loans, etc.
b. Bonds with Sinking Fund Provisions
Bonds with Sinking Fund Provisions have a provision as per which the issuer is required to retire some sum of outstanding bonds every year. The issuer has following options for doing so :
- By buying from the market
- By creating a separate fund which calls the bonds on behalf of the issuer
Since the outstanding bonds in the market are constantly retired by the issuer every year by creating a separate fund (more commonly used option), these types of bonds are named as bonds with sinking fund provisions. These bonds also permit the borrowers to repay the principal over the bond’s life.