Types of Fixed Income Securities
This is an introductory page in fixed income. If you are unfamiliar with any of the terms, you can refer to the Fixed Income Glossary.
A bond is a kind of loan, made from one party (the issuer) to another (the holder). It is a debt security, in which the issuer owes the holder a debt, and is obliged to pay them interest (based on the coupon of the bond), and repay the principal (face value) at a later date, known as the maturity date. Generally, the maturity date of a bond exceeds a year. Interest is typically paid at fixed intervals (either annually, semiannually, or monthly).
Bonds typically trade in the secondary market, and thus ownership is transferable. They tend to be highly liquid (easy to trade), though the liquidity would depend on the specific bond.
Bonds carry counter-party risk, as it is not guaranteed that the bond issuer would be able to meet the interest and principal payments. A bondholder has a creditor stake in the company. In the event of bankruptcy, a bondholder will have absolute priority and will be repaid before stockholders. However, they are not guaranteed to receive the full principal.
Which of the following is the difference between a bond and a stock?
Features of a bond
Numerous features of the bond are fixed in advance, and the standardization of the contract allows for it to be easily traded in the market. The price of the bond is determined by the market. The following features of a bond are fixed:
Principal
The principal, or face value, of the bond is the amount on which the issuer pays interest, and is also (typically) the amount that has to be repaid at the end of the term.
Maturity
The maturity of a bond refers to the time period at which the principal is due.
In the US Treasury, there are several categories of bond maturities:
Very short: Money Market instruments have maturities of less than a year,
Short: Bills mature between 1 to 5 years.
Medium: Notes mature between 6 to 12 years.
Long: Bonds mature in more than 12 years.
Coupon
The coupon is the interest rate that the issuer has to pay to the holder.
A zero coupon bond is a bond that pays no coupons.
A fixed coupon bond is a bond that pays a fixed amount per time period.
A floating rate bond is a bond that pays a (fixed) spread above a money market reference rate. For example, a USD LIBOR + 0.20% bond will pay out more as the LIBOR rate increases. At the start of each coupon period, the coupon is calculated by taking the reference rate for the day and adding the spread. These instruments will carry (almost) zero interest rate risk, and is considered extremely conservative.
The term coupon arose because historically, paper bond certificants had paper coupons attached to them, for each interest payment. On the due date, the bond holder would have to turn in the coupon in order to receive a payment.
Yield
The yield is the rate of return from investing in the bond.
The yield to maturity is equivalent to the internal rate of return of a bond
The current yield is the annual interest payment divided by the current market price of the bond.
Bond issuer
Bonds are issued by government, local governments and corporations.
Bond Price
Bonds are priced through the present value of all of its expected cash flows. For more details, see Bond Valuation and Bond Prices.
Credit rating
This refers to the probability that the bondholders will receive the amounts promised at the due dates. Typically, an issuer that is more credit worthy will be able to obtain a lower yield for its bonds. The US Treasury bonds are often deemed the safest investment opportunity, and could be used to determine a risk-free interest rate.
