Classifications of Bonds

Global debt markets are three times larger than equity markets. As such, there are many ways in which we can classify bonds.

Classification by Type of Issuer

The three bond market sectors are government and government-related sector, corporate sector, and structured finance sector. The government-related sector includes supranational organizations (such as the World Bank), governments, and local governments (provinces, regions, states, etc.). Structured finance is done by securitization that transforms transactions into tradable securities in public markets. Securitized (or asset-backed) securities transfer ownership of assets, i.e., loans and receivables, into a special legal entity.

Classification by Creditworthiness of Issuer

Credit rating agencies determine the issuer’s creditworthiness. Ratings of Baa3 or above by Moody’s Investors Service or BBB- or above by Standard & Poor’s (S&P) and Fitch are investment grade. Ratings below these are non-investment grade, high-yield, speculative, or “junk” bonds. Investment-grade bonds are generally more liquid than high-yield bonds.

Classification by Maturity

Maturities of money market securities such as Treasury bills range from overnight to one year. Corporate sector securities with short maturities are commercial paper and negotiable certificates of deposit. The currency denomination is also distinctive.

Classification by Interest Rate

The currency denomination is also a distinctive feature. For example, if a bond is in British Pounds, then the UK interest rate governs its price. Bonds could pay a fixed rate of interest or a floating rate of interest.

Floating-rate bonds, also called floating-rate notes (FRNs) or floaters, adjust to market interest rates. Interest rate risk is usually the most considerable risk for fixed-income investors. Banks with floating-rate debts, therefore, often issue floating-rate loans to limit the volatility of their earnings and at the same time accommodate investors.

Question

A fixed-income security with a maturity of three months is most likely a:

1. Junk bond.
2. Treasury Note.
3. Money market security.

Solution

The correct answer is C.

The maturity of money market securities range from overnight to one year.

A is incorrect. Junk bonds are simply non-investment grade bonds, but their maturity could be anything.

B is incorrect. Treasure Notes have a maturity of 2 to 10 years.