Describe Different Types of Bonds

Call Provisions

A call provision gives the issuer the option to repurchase the bonds before maturity. The issuer repurchases the bonds at the market price, at par, or at a specified sinking fund price, whichever is the lowest.

Special Bond Arrangements

Sinking fund arrangements are formal plans for retiring the debts that reduce the credit risk of a bond. Typically, the issuer forwards repayments to a trustee. This may be unfavorable for investors due to reinvestment risk (having to reinvest at a lower rate). A floor prevents the coupon from falling below a specified minimum rate in favor of bondholders. Conversely, a cap cushions the issuer by preventing the interest rate from rising above a maximum rate.

Other Types of Bonds

• Floating-rate notes (FRNs) do not have a fixed coupon; but are linked to an external reference, such as the LIBOR. Interests fluctuate during the bond’s life. FRNs generally have quarterly coupons.
• Step-up coupon bonds, either fixed or floating, have coupons that increase by specified margins at specified dates. Such bonds provide protection against rising interest rates.
• Credit-linked bonds have coupons that change in line with the bond’s credit rating.
• Payment-in-kind (PIK) coupon bonds allow the issuer to pay interest in the form of additional amounts of the bond issue rather than to cash payments. As a result, such bonds are favored by issuers concerned with cash flow problems.
• Deferred coupon bonds, sometimes called split coupon bonds, pay no coupons for their first few years but later pay higher coupons. Such bonds are common in project financing.
• Zero-coupon bonds are an extreme form of deferred coupon bonds that pay no interest and, thus, are issued at a deep discount. Zero-coupon bonds defer all interest payments until maturity.
• Index-linked bonds are linked to a specified index offering protection for the investors. Some common indices are the UK Retail Price Index (RPI) or the US Consumer Price Index (CPI). Indices are transparent and regularly published. In addition, governments usually issue inflation-linked bonds or linkers.

Question

Which type of bond is an extreme type of deferred coupon bond and is expected to defer all interest payments until maturity?

1. Zero-coupon bonds.
2. Credit-linked coupon bonds.
3. Index-linked bonds, linkers in the UK.

Solution

The correct answer is A.

Effectively, zero-coupon bonds defer all interest payments until maturity.

B is incorrect as credit-linked coupon bonds are not about a deferral of coupon interest but a protection for changes in credit rating.

C is incorrect because an index-linked bond is linked to a specified index but interest payments are not necessarily deferred.