What is aBond? Types of Bonds Explained with Pros and Cons

Bonds are loans made by investors to borrowers like governments and businesses. The lender utilizes the funds to support its operations while paying interest to the investor. Municipal, corporate, and government bonds are the most prevalent types of bonds.

The bond can frequently be modified. In other words, the instrument’s present owner or issuer may sell the instrument’s ownership in a secondary market. This suggests that the bond is very liquid on the secondary market once the bank medallion’s transfer agents stamp it. The bond price in the secondary market may differ significantly from the principal due to many factors considered in the bond valuation.

What Is a Bond?

A bond is an instrument used in finance where the issuer or debtor is obligated to pay the holder or creditor a debt. It depends on the conditions—to pay interest over a predetermined period and the principal (the amount borrowed) at maturity. The interest is typically due at predetermined intervals, such as semiannually, annually, and less frequently at various times. A bond is, therefore, a type of loan or IOU. With the help of bonds, the borrower can finance long-term investments or, in the case of government bonds, current expenses.

Bonds are tradable assets that are securitized versions of corporate debt issued by businesses. Because bonds typically pay debtholders a fixed interest rate (coupon), they are classified as fixed-income instruments. Interest rates that fluctuate or float are also now fairly standard. Interest rates and bond prices are inversely associated; when rates rise, bond prices decline, and vice versa. Bonds have maturity dates, after which the entire principal must be repaid to avoid default.

Example: As an illustration, think about the case of Ezechiel Corporation. Assistance is required to finance the $2 million loan from a bank that Ezechiel needs to construct a new plant. Ezechiel plans to sell investors bonds worth $2 million to raise the money instead. Ezechiel agrees to pay its investors 10% interest each year for ten years in two equal installments. Ezechiel sells 2,000 bonds because each has a face value of $2,000.

In Terms of Issuers’ Classification, How Many Types of Bonds are There?

According To The Issuer, there are 9 (Nine) types of bonds. Those are,

1. Corporate Bond
2. Treasury Bond
3. Municipal Bond
4. Agency Bond
5. GSE Bond
6. Investment-Grade Bonds
7. High-Yield Bonds
8. Foreign Bonds
9. Mortgage-Backed Bonds

These bonds are explained below with their pros and cons.

Corporate Bond

Similar to an IOU (I owe you), a corporate bond is a debt obligation. Purchasers of corporate bonds make loans to the issuing corporation. In exchange, the business agrees in writing to pay interest on the principal and, most of the time, to return the principal when the bond matures. Investment-grade and speculative-grade (or high-yield) bonds are the two main credit categories that apply to corporate bonds.

Pros 

• Corporate bonds can yield higher than government bonds.
• In corporate bonds, the investors can access their principals even if the bond is not matured.

Cons

• Due to high credit risk, the investor may only get the principal or the interest returned if the company goes out of business.

Treasury Bond

Pros

To finance public spending, a government will issue government or sovereign bonds. Typically, it promises to pay reoccurring interest, sometimes coupon payments, and return the face amount on maturity. Treasury marketable securities are available in five varieties within the Treasury bond category: Treasury Bills, Treasury Notes, Treasury Bonds, Treasury Inflation-Protected Securities (TIPS), and Floating Rate Notes (FRNs).

• You will get immunity from local or state income taxes for the profit you gain from treasury bonds.
• The activeness of the treasury market gives it liquidity, making trading easier for investors and adding varieties in maturity.

Cons

• With the comparatively low risk, the yield is more on the lower side.

Municipal Bond

Municipal bonds, also referred to as “muni bonds,” are a particular category of bond issued by the state, local, or other governmental entities, as well as the authorities and special districts they create. In the US, holders of municipal bonds may occasionally, but not usually, be exempt from paying both federal and state income taxes on their interest income. Establishing schools is one example—the construction of infrastructure and a library construction (roads, bridges, public transit).

Pros

• Being more stable, municipal bonds are less-risky compared to stocks.
• The fixed interest rate will give you a steady income source.

Cons

• A municipal bond market is not that active, and you may face liquidity issues.

Agency Bond

Agency debt also referred to as an agency bond or agency security, is a bond issued by a federal budget agency or a government-sponsored institution. The US government encourages but not guarantees the services these groups provide. Because some agency bonds are callable, their issuer may repay them before their maturity date. The two agency bond categories are federal and government-sponsored enterprise (GSE) bonds.

Pros

• They provide higher returns relative to treasuries.
• Highly liquid: They are actively traded and hence, are highly liquid.

Cons

• Agency Bonds offer to return lower than Corporate Bonds and carry high-interest rate risk in a rising interest rate scenario.

GSE Bond

Agency bonds are those issued by organizations sponsored by the federal government or GSEs. GSEs are independent companies with federal support established for a public purpose. Bonds from agencies are frequently sold in $1,000 increments. Federal income tax is due on interest income and capital gains and losses from most GSE securities.

Pros

• improve credit flow in some regions of the United States economy.
• provide financial services to the public for various things, particularly mortgages, through capital market liquidity.

Con

• Agency bonds issued by a GSE have the same full faith and credit backing as the backing of the federal government.

Investment-Grade Bonds

Investment grade refers to the quality of a company’s credit. Investment-grade bonds are believed to have a lower risk of default and receive higher ratings from credit rating agencies. These bonds tend to be issued at lower yields than less creditworthy bonds.

Pros

• They provide a predictable income stream. Typically, bonds pay interest twice a year.
• it’s a good fit for conservative investors, income investors, and retirees looking to balance their portfolios.

Con

• They have less liquidity.

High-Yield Bonds

In finance, a high-yield bond is a bond that is rated below investment grade by credit rating agencies. These bonds have a higher risk of default or adverse credit events but offer higher yields than investment-grade bonds to compensate for the increased risk. High-yield bonds are debt securities, also known as junk bonds, that corporations issue.

Pros

• High-yield bonds supply a consistent income stream that few other assets can match.
• the high yield sector generally has a low correlation to other sectors of the fixed-income market, along with less sensitivity to interest rate risk.

Con

• The biggest problem with high-yield bonds is the fact that these bonds tend to be callable.

Foreign Bonds

A foreign entity that wants to raise money will issue a foreign bond in the currency of the home market. International businesses that do a lot of business on the local market frequently issue foreign bonds, including bulldog bonds, matilda bonds, and samurai bonds. For instance, the Yankee bonds traded in the United States, the Bulldog bonds traded in the United Kingdom, the Matador bonds traded in Spain, and the Samurai bonds traded in Japan.

Pros

• Foreign bonds create a channel for borrowers to access new capital markets.
• they allow buyers to get their hands on foreign currency.

Cons

Foreign bonds face inflation risk.

Mortgage-Backed Bonds

A mortgage-backed security is a type of asset-backed security secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to individuals who securitize or package the loans into a security that investors can buy.

Pros

• Mortgage-backed securities typically offer higher yields than government bonds.
• It is a safe investment with an attractive yield.

Cons

• There is always a risk that borrowers will make higher-than-expected monthly payments.

According To Features, How Many Types of Bonds are There?

In this part, we have 8 (eight) types of bonds.

1. Fixed Rate Bonds
2. Floating-Rate Bonds
3. Zero Coupon Bonds
4. Perpetual Bonds
5. Inflation Linked Bonds
6. Convertable Bonds
7. Callable Bonds
8. Puttable Bonds

These bonds are explained below with their pros and cons.

Fixed-Rate Bonds

Fixed-rate bonds pay consistent interest amounts until maturity. The bondholders earn predictable and guaranteed returns regardless of the prevailing market conditions.

Pros

• You can get assurance of fixed income through coupons.
• Fixed-rate bonds add diversity to your portfolio and balance the market volatility with the certainty of income.

Con

• The investors must wait to withdraw the bond and get the principal back before it matures.

Floating-Rate Bonds

Floating-rate bonds do not pay fixed returns each period. Instead, the interest rates vary during the tenure depending on the set benchmark.

Pros

• The interest is always in sync with the market, avoiding instability.
• You will get a higher interest rate compared to fixed-income investments.

Con

• You will have to take the credit risk regarding floating bonds.

Zero-Coupon Bonds

These bonds don’t pay periodic payments during their tenure, as the name would suggest. These bonds are redeemable at par value and were issued at a discount. The yield for investors makes a difference.

Pros

• No reinvestment risk as the money will be reinvested automatically at the annualized rate.
• Being a prevalent bond, the zero-coupon bond market has lots of investors and buyers making an active market, resulting in high liquidity.

Con

• The investors would be subjected to taxes.

Perpetual Bonds

Perpetual bonds are those debt securities that do not have a maturity date. In this type of bond, the issuer does not repay the principal amount to the bondholders. Though, they keep paying steady coupon payments to the bondholders till perpetuity.

Pros

• Investors will not have to worry about reinvesting their matured bonds.
• As these bonds are subordinates of more prominent corporations, investors feel safe.

Con

• Due to its infinite nature, the investors would have to agree to take insolvency risk.

Inflation-Linked Bonds

These types of bonds aim to minimize inflation’s impact on the face value and coupon payments. The principal is adjusted according to inflation, and coupon payments are made based on the adjusted principal.

Pros

• Adds a good balance and diversity to your portfolio.
• Your interest rate will increase in sync with the inflation rate, leaving you with less worry.

Con

• There is an annual investment limit to this type of bond. 

Convertible Bonds

The investors holding convertible bonds get the right to convert the glue to a predefined number of equity shares in the issuing company at a particular time from the tenure. The investor can also opt to receive the principal repayment at maturity if they don’t want to exchange it with shares.

Pros

• it is a perfect alternative to equity funding, great for start-up businesses.
• The voting rights stay reserved to the company until conversation; hence, there’s no loss of control.

Con

• Convertible bonds get less priority compared to regular bonds. In case of bankruptcy, these shareholders would be subordinate to common shareholders.

Callable Bonds

Callable bonds are high coupon-paying securities that give the issuer the right to call back the bonds at a pre-agreed price and date.

Pros

• Works well for companies to raise capital.
• The investors get a chance to recall and then reinvest.

Con

• Investors seldom replace callable bonds with Lower-rate products.

Puttable Bonds

Puttable bonds give the bondholder the right to return the bond and ask for principal repayment at a pre-agreed date before maturity. Since the benefit offered is for investors, these bonds pay lower returns.

Pros

• The price of a puttable bond can get as high as the price put.
• The bondholders get the advantage of flexibility in selling the bond.

Con  

• Offers a lower yield because of the put.

Some Other Types Of Bonds

We have two kinds of bonds which we have categorized in the other bond type.

Retail Bonds

Retail bonds are a type of corporate bond primarily designed for ordinary investors.

Pro

• Retail bonds may open up the path to alternative investments and funding options.
• This bond will help to increase interaction with the company’s customer base and reflect loyalty.

Con

• The income you get in return may be low.

Foreign Currencies

A convertible bond issued in a currency other than the issuer’s home currency is a foreign currency convertible bond (FCCB). In other words, foreign currency is used to raise funds by the issuing company. A product that combines debt and equity is known as a convertible bond. A convertible bond is a hybrid financial instrument that combines debt and equity. A foreign entity issuing a bond in the home market’s currency to raise money is considered a foreign bond.

Pros

• It offers higher yields than domestic bonds.
• It also offers a diversified portfolio in investment.

Cons

• Unfavorable and unexpected foreign exchange moves and rate changes, and policies make it a risky business.

Bottom Line

Businesses and other government agencies issue different types of bonds as financial tools to raise money for asset purchases and deficit financing. The bond issuer basically borrows money from the buyer by promising to pay interest regularly over a defined period. The bond functions as a contract between two parties because it contains clauses outlining the bond issuer’s obligations to the bondholder. Bondholders are among the creditors of a corporation, whereas shareholders are the latter’s owners. In addition, bonds can be categorized based on their intended use, such as school, airport, equipment, or general improvement bonds. BA bond’s status as secured or unsecured depends on whether the bondholder has a specific claim against the issuer’s assets. Bond principal and interest payments may differ and may be registered or unregistered. Unregistered bonds are also referred to as bearer bonds.

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