Question

Coupon, Discount, Sinking, Floating, Call, Municipal, Income, Index, and Junk bonds.

Describe the distinguishing features of eight (8) of these bonds, Explain with examples which bond pays the highest return and which bond pays the lowest return and Why?

Answer 1

Coupon : This is a bond that pays interest over the life of the bond. Zero-coupon bonds are also available which do not pay any interest over the lifetime of the bond, but are available at deep discount during purchase of the bond. The coupon can be either fixed or floating.

Discount : This bond sells at a discount meaning they are available for purchase at a price lesser than the par value.

Sinking fund bond : This is a type of bond where the issuer sets aside the money that is supposed to be paid to the bond holders. Such a provison/fund is created to ensure that the bond holders are paid properly even if the issuers isn't able to pay back in the future. It serves as a collateral to the bond holders.

Floating Rate Bond : These bonds offer interests that are linked to a specific reference rate like the LIBOR.

Callable Bond : One where the issuer has the right to redeem or pay off the bonds even before the specified maturity. These bonds typically offer a higher rate of interest than other bonds.

Municipal Bond : This is a bond where the issuer is the state/municipality and is used to raise funds for capital expenditures like buidling of roads, funding a healthcare project, etc. Interest rates are low because nature of default is very low

Income Bond : It is a rare type of bond where the issuer promises only to pay the face value of the bond. Any interest or coupon is paid only if the issuer makes enough income. This also offers a higher rate of interest due to the varied nature of the coupon payments.

Index Bond : This is a type of bond whose coupon is linked to an index, most common one being the inflation index.

Junk Bond : These bonds are the ones whose issuers are classified as "Risky" by the credit rating agencies. Generally, corporates that are "BB and below" by the S&P or "Ba and below" by Fitch come under this category. The rate of interest offered is quite high for this bond.

Highest Returns : Junk Bonds/Income Bonds provided issuer doesn't default

Lowest Returns : Municipal/ coroporate bonds because they don't default easily.