1.1.         Plain Vanilla Bonds

a.  The most common types of bonds are plain vanilla bonds. These bonds have a fixed rate of coupons or interest that is paid each year and at the end of the term of the bond, the investor receives the principal along with the interest for that year.

b.  The timeline of a typical plain vanilla bond looks like this:

1.2.         Amortizing Bonds

a.  Amortizing bonds are bonds that have a fixed payment schedule for not only interest but both interest and principal portion.

b.  Amortizing bonds are of two types, i.e. fully amortizing bonds and partially amortizing bonds.

c.  The fully amortizing bond has a fixed payment schedule for the interest and payment so that the balance of principal becomes zero at the time of maturity.

d.  A partially amortizing bond is the one where there is a fixed payment of interest and some portion of principal during the life of the bond and a balloon payment for the balance of principal at the time of the maturity.

1.3.         Sinking Fund

a.  A sinking fund is a plan by the issuer to set aside the funds in order to retire the bond’s principal over time. According to this plan, some percentage of the bond issue must be repaid each year.

b.  The issuer pays some amount (usually a fixed percentage) of the bond’s principal to the trustee of the bond, who redeems the bonds each year through either the open market purchases or through some serial number lottery.

c.  The issuer may call for some fixed percentage or some increasing percentage of bonds each year to be redeemed out of the funds in the sinking fund. The call may also be of the callable portion of the bonds.

d.  The sinking fund reduces the risk of default on the bonds, but, at the same time also increases the reinvestment risk or call risk.

1.4.         Coupon Payment Structure

1.4.1.     Fixed Coupons

a.  The coupons or interest payments may be fixed at a certain percentage each year.

b.  The payment of the coupons may be made annually, semi-annually, quarterly, or at any other frequency, as mentioned in the bond indenture.

c.  The fixed coupon structure makes the cash flows certain for the issuer.

d.  The fixed coupon bonds have high price volatility but are easy to price.

1.4.2.     Floating Rate Coupon

a.  The floating rate interest is paid at a reference rate plus spread or margin.

b.  The reference rate is a fixed percentage and is mentioned in the bond’s indenture.

c.  The margin or spread depends upon some other percentage such as LIBOR, which is fluctuating or variable.

d.  The floating-rate coupon bonds are characterized by uncertainty in cash flows.

e.   These bonds have little price volatility but are difficult to price.

f.  The floating-rate coupon bonds may either have a cap or a floor rate. The cap rate specifies the maximum amount of coupons that can be paid, and the floor rate specifies the minimum amount of coupons that must be paid. The caps are for the protection of the issuer, whereas, the floors are for the protection of the bondholder.

g.  Sometimes the bonds may have both caps as well as a floor. This strategy is called a collar.

1.4.3.     Inverse Floating Rate Notes

Inverse FRNs are the bonds whose coupon payments increase with a fall in the floating rate.

1.4.4.     Step-up Coupon Bonds

a.  These are the bonds on which the coupon increases by specified margins at the specified dates.

b.  These bonds may be fixed or floating.

c.  The step-up coupon bonds increase the call risk.

1.4.5.     Credit-Linked Coupon Bonds

a.  These bonds protect the investors from any credit risk or price risk due to credit downgrades.

b.  These bonds otherwise have fixed coupons, but if there is an increase or decrease in the credit ratings, the coupon rates decrease or increase, respectively. So, if there is an increase in the credit rating of the bond, the coupon payments decrease, and vice-a-versa.

1.4.6.     PIK (Payment-in-Kind) Coupon Bonds

a.  These are the bonds, whose payments of interest are made through the further issue of bonds or through the issue of common shares.

b.  The payment in kind is usually dependent upon a PIK toggle, which gives the issuer a choice between payment in cash or kind. This PIK toggle is generally tied to the cash flow trigger, i.e. if the cash flows are below a certain level; the issuer has the option to pay the coupons in kind.

1.4.7.     Deferred Coupon Bonds

a.  These are the bonds that make no coupon payments for the first few years and then followed by a higher coupon than otherwise payable.

b.  This also results in the deferment of tax on interest income.

1.4.8.     Index-Linked Bonds

a.  The coupon payments on these bonds are linked to some index.

b.  For example, inflation-protected bonds are usually linked to the inflation index such as the consumer price index. On such bonds, the payment of coupons increases with an increase in inflation.

c.  The inflation adjustment to such bonds may be made to either the coupons or the principal.

d.  For example, say there are 4%, $ 1,000 inflation-linked bonds and the CPI for the period comes period comes out to be 5%, then:

     i.  If it is a zero-coupon bond, the principal would be adjusted for the inflation and the repayable principal is $ 1050 (i.e. $ 1,000 + 5% of $ 1,000).

    ii.  If it is a fixed principle floating rate bond, the coupon payment of $ 40 would be adjusted for the inflation to $ 42 (i.e. $ 40*1.05)

    iii.  If the bond’s principal is inflation-adjusted and the interest is payable on the adjusted principal, then the adjusted principal would be $ 1050, and the coupon payment to be made would be $ 42 (i.e. 4% of $ 1050).

   iv.  If the bonds are fully amortized, both interest and principal payment increase with an increase in CPI.

1.4.9.     Equity Linked Notes

These are the principal-protected notes, which are zero-coupon bonds having a call option.