Describe Different Types of Bonds

Call Provisions

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 debt that reduce the credit risk of the 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 prevents the interest rate from rising above a maximum rate to protect the issuer.

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 in a way other than with cash payments. Such bonds are favored by issuers concerned of 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 usual indexes are the UK Retail Price Index (RPI) or the US Consumer Price Index (CPI). Indices are transparent and regularly published. Governments usually issue inflation-linked bonds or linkers.

Question

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

A. Index-linked bonds, linkers in the UK

B. Credit-linked coupon bonds

C. Zero-coupon bonds

Solution

The correct answer is C.

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

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

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

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Describe different types of bonds and their specific features

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