Types of Bonds

Short Descriptions of Bonds with Varying Characteristics

There are many ways to characterise and group types of bonds. Beginning investors sometimes like to know: what is a coupon and how does it work?  what do the terms “derivatives” and “futures” mean related to bonds? This section gives short descriptions about bonds with varying characteristics. Use the Glossary to get definitions for other terms.

Fixed-rate Bonds - Sometimes known as a conventional or plain vanilla bond, this is a bond which pays a regular fixed interest rate over a fixed period of time to maturity with the return of principal on the maturity date.

Index-linked bonds - Bonds whose face value and interest payments are linked to an index. The best known are inflation-linked bonds, in which the face value and interest payment are linked to a consumer retail price index, and thus the investor receives a return that is inflation protected.

Zero Coupon Bonds - Bonds which do not carry a coupon (no coupon); the return on the bond comes from the fact that they are sold at a significant discount to the eventual redemption value.

Floating-rate Bonds - Bonds whose interest rate is tied to a reference rate such as LIBOR or EURIBOR. Sometimes called Floating-rate notes, FRNs, or floaters.

Convertible Bonds - A bond that provides the investor an option to exchange the bond for a preset number of shares in the issuer at a preset price and time.

Derivatives - Derivatives are complex and varied financial instruments with values that change in response to changes of the underlying assets, interest rates, currency exchange rates or indices. The main types of derivatives are futures, forwards, options and swaps. Derivatives are sometimes known as “synthetics.”

The main purpose of a derivative is to reduce risk to one party. Futures or forwards derivatives are contracts to buy or sell an asset at a specific price on a specified future date. Options give the holder the right to buy or sell an asset on a specified future date. The most common form of swap is an interest rate swap. These derivatives allow investors to profit from a falling, rising or static market.

Derivatives may be investments in their own right or may be used to build other investment vehicles such as structured products. There is debate in the financial community as to whether derivatives are suitable for individual investors due to their complexity. It is always advisable to consult a financial advisor when considering any investment related to a derivative.

Financial Futures - A financial future is a contract agreeing to buy or sell a specified amount of an underlying financial instrument at a specific price on a specified future date. There are three main types of financial futures: interest rate futures; stock index futures or currency futures. Because futures are complicated and risky, with the potential for losses not limited to your original investment, futures products are not suitable for many individual investors.

 

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