Nonconventional Bonds

Most bonds are conventional bonds, (aka vanilla bonds, or — more verbosely — plain-vanilla bonds), having only a specified face value, interest payment frequency, interest rate, and maturity date. Nonconventional bonds (aka non-vanilla bonds) have different characteristics: interest rates and maturity dates may vary, or they may have additional characteristics to appeal to specific investors, such as floating rates, embedded options, and attached warrants.

The most common type of nonconventional bond is a zero-coupon bond, so named because it pays no coupons. Instead, the bonds are bought at a discount and the interest is earned that maturity when the bondholder receives the face value of the bond. Governments and corporations are the main issuers of zero-coupon bonds. Sometimes coupon bonds are stripped, forming zero-coupon bonds from each coupon payment and the principal repayment, which are sold as individual securities. In most cases, the stripping is done by a brokerage rather than by the issuer, to provide a greater variety of fixed income securities to sell to its customers. Common strips include TIGERS (Treasury Investors Growth Receipts), which are stripped Treasuries, and stripped mortgage-backed securities. U.S. Treasury also issues STRIPS (Separate Trading of Registered Interest and Principal of Securities), which are pre-stripped securities. Although zero-coupon bonds do not pay periodic interest, taxes are, nonetheless, assessed on the imputed interest earned annually, which is the interest prorated over the term of the bond.

Index-linked bonds have either interest payments or the principal payment, or both, link to an index, usually a consumer price index, since the real return of bonds, especially long-term bonds, is usually decreased by inflation. Bonds can also be linked to commodity prices or a stock index.

Floating rate notes pay a variable interest rate, which contrasts with the fixed rate paid by most bonds, so technically, they are not fixed income securities, but are considered money market instruments. Generally, the rate is linked to a variable rate that serves as a benchmark, usually a bank lending rate, such as the 3-month LIBOR, paying a fixed amount, known as the spread, over the linked rate. For instance, a floating rate note may pay the 3 month LIBOR rate + 50 basis points. Resetting the yield usually resets the bond's market price to the par value. However, par value may not be achieved because of increased risks or other factors that affect the pricing of the bond. For instance, if the credit rating of the note has declined, then coupon resets will not return the market price of the bond to par value. Rate resets usually occur on coupon dates. Sometimes, the spread itself is variable, in which case it is referred to as a variable rate note.

Most bonds repay the principal as a single payment at the end of its maturity, which is known as a bullet payment. For this reason, conventional bonds are also known as bullet bonds. Amortizing bonds, on the other hand, repay the principal over a series of payments rather than all at once on the maturity date, so some or all of the periodic payments will consist of both interest and principal.

Bonds can also have embedded options. The 3 major types of embedded options include being callable or putable, and convertible. Many bond issuers issue callable bonds, so that if interest rates decline, they will be able to call back the bonds and issue new bonds with a lower interest rate. Callable bonds generally have a call protection period, specified in the bond indenture, during which time the bond is non-callable. Such bonds are referred to as deferred callable bonds. Callable bonds may be discretely callable or continuously callable. Discretely callable bonds may only be called on dates specified in the bond indenture. Continuously callable bonds may be called at any time after the call protection period.

When the bonds are called, the issuer often pays a premium, refer to as the call premium, that is often equal to an annual coupon payment. Issuers will only call a bond if interest rates have declined, so that they can issue new bonds with a lower yield. Hence, the disadvantage of callable bonds is that they are likely to be called when bond prices rise, which is exactly when the bondholder would like to keep the bond. Furthermore, there is a higher reinvestment risk, because once the bond is called, then the investor will have to reinvest the money at lower interest rates for the same amount of risk. Noncallable bonds will increase in price as market yields decline, but callable bonds will be capped at their call price, leading to what is referred to as call compression.

To appeal to investors who worry about interest-rate risk and who are willing to accept a lower interest rate without the risk, some issuers issue putable bonds, where, at specified times, the bondholder is permitted to sell the bond back to the issuer for the face value, even if interest rates have increased, which will generally lower the value of the bonds without the put feature. For both callable and putable bonds, the call or put provision can only be exercised after a minimum amount of time that is specified in the bond indenture. Some bonds have a sinking fund provision, where a set number of bonds of a particular issue are called at random on specified dates.

The yield the most bonds is generally designated by the yield to maturity, but callable bonds generally use a shorter period that ends with the earliest call date. When the yield is based on the call date, then it is referred to as the yield to call. Likewise, the yield on a putable bond is based on a term length equal to the earliest put date, which is referred to as the yield to put.

A convertible bond gives the bondholder the right, within specified times, to convert the bond into a specified number of shares of company stock. Investors will accept a lower interest rate for the chance to earn a much higher profit, should the stock price of the issuer increase above the convertible price.

Bond warrants provide bondholders with the right to buy more bonds by the same issuer at a more favorable price than what can be obtained in the market. Like stock warrants, bond warrants are often detached from the bond and traded separately.

Nonconventional Bonds Are Difficult to Value

The price of a bond is generally determined by the present value of its future payments, including interest payments plus the principal repayment. However, the present value of any investment can only be known if both the cash flow from the investment and the dates on which the payments are received are known. Some types of nonconventional bonds, such as zero-coupon bonds and amortizing bonds, can be accurately priced because both the cash flows and the term of the bond are known before hand. However, because many types of nonconventional bonds have uncertain payments or variable terms, they cannot be valued like conventional bonds. In some cases, assumptions are made so that the present value of the cash flow can be calculated. For instance, in the case of callable bonds, the present value can be calculated using the earliest call date. In other cases, such as with floating-rate notes, index-linked bonds, and especially convertible bonds and bonds with warrants, projections about cash flow must be made.