Type of interest
Fixed rate bonds
Fixed rate bonds pay a fixed rate of interest (the coupon rate) for the life of the bond. Because fixed rate bonds pay interest at a fixed rate, they carry interest rate risk as well as credit quality risk. If market interest rates rise or the financial health of the issuer deteriorates, investors will demand a greater yield and the price of the bond will fall. Governments mostly tend to issue fixed rate bonds.
Floating rate bonds
Floating rate bonds make interest payments that are tied to some measure of current interest rates. A common measure is the 90 day bank bill swap rate or BBSW (a benchmark rate calculated by compiling an average of market rates supplied by certain approved banks for the sale and purchase of 90 day bank bills). Typically, the coupon will be expressed as a fixed margin above the benchmark rate (eg BBSW plus 2%). There are several names used interchangeably to describe a bond that pays a floating rate of interest, including a floating rate note, FRN or floater. Corporates tend to be more active in issuing floating rate bonds than governments.
Indexed bonds are generally medium to long-term bonds. The face value of the bond is adjusted periodically for movements in a nominated index, such as the Australian Consumer Price Index (CPI) or an index tied to the price of a particular commodity. Interest is usually paid at a fixed rate on the adjusted face value. At maturity, investors receive the adjusted face value of the indexed bond plus the final coupon based on the adjusted face value. Indexed bonds that are tied to a general measure of inflation (such as the CPI) ensure that you receive a return above the inflation rate throughout the entire life of the bond, giving you security whilst eliminating inflation risk. To compare the expected coupon payments on an indexed bond tied to CPI with that of a fixed rate bond, you simply add the expected inflation rate to the coupon rate of the indexed bond.
Type of issuer
Government bonds - Treasury Bonds (or ‘TBs’) and Treasury Indexed Bonds (or TIBs). TBs are fixed rate bonds and, as the name implies, TIBs are indexed bonds linked to the CPI. TBs and TIBs are usually issued in series, with each series having its own coupon rate and maturity date, some from less than one year and others to over fifteen years. They make up the largest single pool of bonds in the market and offer a wide range of bond series. Market makers also provide tight bid and offer prices for all TBs and TIBs quoted on ASX, providing investors with very high levels of liquidity. Given the size of the market, the liquidity and security of government bonds is unrivalled.
There are a variety of corporate bonds traded on ASX. The terms of corporate bonds can vary quite markedly and therefore it is important that you read the prospectus or term sheet for an individual bond to understand its terms. It is also important that you assess the creditworthiness of the issuer of the bond as that too can vary markedly between issuers.
In practice, the corporate bond market on ASX is far less liquid than for bonds issued by governments. As a general rule, safer bonds with a better credit standing promise lower yields to maturity than other corporate bonds with similar maturities. ‘Junk bonds’, also known as ‘high–yield bonds’, are speculative-grade bonds which typically will have a low credit standing and therefore promise higher yields to maturity than other corporate bonds with similar maturities. The important rule to remember is the higher the bond issuer’s perceived credit risk, the higher the bond’s yield needs to be to compensate you for that risk.
Simple and complex bonds
Bonds include a very broad array of different products that have markedly different terms and conditions. They range from so-called “simple bonds” to some very complex debt securities. (Read the 'Understanding bonds' booklet for more information). That’s why it’s so important to read the prospectus or term sheet for a bond to understand the particular terms and conditions that apply to that bond. A bond is regarded as a “simple bond” if:
- it has a fixed or floating coupon rate that does not change for the life of the security;
- interest payments under the security are paid periodically and cannot be deferred or capitalised by the issuer;
- it has a fixed maturity date which is not more than 15 years after its date of issue;
- it is not subordinated to other debts owed to unsecured creditors generally; and
- it does not attach any options to convert it to equity or to extinguish it (so-called “knock-out” options).
Examples of more complex bonds include:
- bonds that allow the issuer to defer or capitalise interest payments under certain conditions;
- bonds that provide for the coupon rate to be re-set at certain times (often called “re-set” or “re-settable” bonds);
- bonds that give the issuer the option to extend them but at the price of paying a higher coupon rate (typically called “step-up bonds”); and
- bonds that are more properly characterised as “hybrid securities”, in that they combine features of debt securities and equity securities. Examples include convertible or converting bonds, perpetual bonds , subordinated bonds and knock-out bonds.