A bond is a security issued by a country or company which offers an investor the opportunity to lend a certain amount of money, for a specific period of time in exchange for an interest rate paid by the issuer. The amount of money lent equals the nominal value of the bond, also called the face value of the bond. An investor who buys 10 bonds with a nominal value of 1000 each is thus lending the issuer of the bond 10,000. The offered interest rate determines the return investors will get. Investors receive the interest in the form of coupon payments. For example, an interest rate of 5% on a bond with nominal value of 1000 thus offers a coupon payment of 50 per year. Bond values change when market interest rates change. Bonds thus are exposed to interest rate risk which can be measured by calculating the duration and convexity.
Fixed rate bond
Fixed rate bonds are the most common and simple type of bonds present in financial markets. As suggested by its name, fixed rate bonds offer a fixed interest rate over their maturity and distribute these returns through coupon payments. In many cases, coupons are paid on an annual basis although this can also be done multiple times a year (e.g. quaterly). As shown in interest rate compounding, more frequent coupon payments improve investors’ final return on investment.
Zero coupon bond
Zero coupon bonds are fixed rate bonds which do not distribute any coupon payments over their maturity. Nevertheless, these bonds still generate a return for investors. Consider the following example. An investor buys a zero coupon bond for a 1000. Although the investor only lent out a 1000, the issuer will repay a higher nominal when the bond matures, e.g. 1100. As such, the return on investment for the investor equals 10%. The zero coupon bond is thus offered below its nominal value and its return will come through capital gains instead of coupon payments.
Floating rate bond
Floating rate bonds pay a variable interest rate that typically equals the prevalent market interest rate plus an additional spread. The additional spread depends on the perceived riskiness of the issuer. The interest rate is typically set at the end of every month, quarter, or year.
Bonds issued by a country are called government bonds. These bonds can have any of the previously discussed characteristics. When government bonds with a maturity lower than one year are issued, they are often referred to as money market securities. The most well-known example of such a short-term bond is US T-bills. Typically government bonds are perceived as safe. They typically offer a lower return than corporate bonds.
Corporate bonds are, as its name suggests, issued by companies to support their financing needs. These bonds can also have fixed, floating or zero coupon characteristics. Typicall,y corporate bonds are perceived as riskier and thus offer a higher return than government bonds, although this is not always the case.
Bonds can have widely different characteristics. Investors should be aware of these to be able to compare them. The issuer, maturity, offered return, nature of the return, and the way this is distributed are among the most important elements that characterise a bond.