WHAT IS A BOND?
Bonds are a type of debt security. They are effectively an IOU between a borrower (the issuer of the bond) and a lender (the investor who purchases the bond) – just as a bank deposit is effectively an IOU between the bank as borrower and the depositor as lender. When a government, corporation or other entity needs to raise money, they can borrow money from investors by issuing bonds to them. Investors who purchase a bond from an issuer are essentially lending money to the issuer for a fixed period of time. In return, investors receive an instrument (the bond) promising that they will receive interest payments at certain intervals and also have their principal returned on a stated future date. Where the bond is quoted on a stock exchange, such as ASX, the investor can realize their investment by selling that bond to another investor at the current market price.
THE DIFFERENT TYPES OF BONDS:
They can be broadly classified into either:
- The type of interest they pay (fixed, floating or indexed); or
- The issuer (government or corporate).
Fixed rate bonds
Fixed rate bonds pay a fixed rate of interest (the coupon rate) for the life of the bond. Because fixed rate bonds pay interest at a fixed rate, they carry interest rate risk as well as credit quality risk. If market interest rates rise or the financial health of the issuer deteriorates, investors will demand a greater yield and the price of the bond will fall.
Floating rate bonds
Floating rate bonds make interest payments that are tied to some measure of current interest rates. A common measure is the 90 day bank bill swap rate or BBSW (a benchmark rate calculated by compiling an average of market rates supplied by certain approved banks for the sale and purchase of 90 day bank bills). Typically, the coupon will be expressed as a fixed margin above the benchmark rate.
Indexed bonds are generally medium to long-term bonds. The face value of the bond is adjusted periodically for movements in a nominated index, such as the Australian Consumer Price Index (CPI) or an index tied to the price of a particular commodity. Interest is usually paid at a fixed rate on the adjusted face value. At maturity, investors receive the adjusted face value of the indexed bond plus the final coupon based on the adjusted face value. Indexed bonds that are tied to a general measure of inflation (such as the CPI) ensure that you receive a return above the inflation rate throughout the entire life of the bond, giving you security whilst eliminating inflation risk. To compare the expected coupon payments on an indexed bond tied to CPI with that of a fixed rate bond, you simply add the expected inflation rate to the coupon rate of the indexed bond.