Bonds: definition, types of bonds, fixed and variable rates

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Classification of bonds by nature

Bond of 500 francs at 5%, 1901

Bonds convertible into shares

These are bonds whose issuance contract provides that they may be converted into shares at specified periods or at any time at the request of the holder.

Extendible bonds

These are bonds that can be extended at a rate and for a period specified when they are issued, beyond the redemption date.

Exchangeable bonds

The issuance contracts of such bonds stipulate that from a certain date and for a certain period of time, fixed rate bonds can be exchanged for variable rate bonds (or vice versa).

Bonds with warrants

One or more warrants are attached to the bonds, these warrants giving the right to subscribe for a fixed period to new shares. This product therefore makes it possible to become a shareholder while remaining a bondholder.

Zero-coupon bonds

They are characterised by the absence of interest payments during the life of the bond. The yield is the difference between the capital paid at issue and the capital redeemed at maturity.

Indexed bonds

These are bonds whose coupon and/or capital repayment are fully or partially indexed to a reference value (e.g. the turnover of the issuing company, the price of a product, etc.). Indexation protects the holder against a depreciation of the coupon or capital in the event of inflation.

French fungible treasury bonds (OATs)

From a technical point of view, these bonds are no different from traditional government bonds, their originality lies in their assimilable nature. The assimilation technique consists in linking the issue to an old tranche of the loan. The State reserves the right to issue additional tranches whose issue price is adjusted according to the market, but whose issue characteristics remain unchanged (term, maturity, nominal value, etc.).

Profit participation certificates

These securities constitute a type of transferable security intermediate between a share and a bond. Market practice assimilates these securities to bonds. The interest paid to the bearer consists of a fixed portion and a variable portion indexed to the issuer's earnings. 

Perpetual subordinated notes

These are perpetual debt securities whose principal is in theory never repaid and whose interest payment can be deferred if no dividend is paid to shareholders.

Redeemable subordinated notes

They are comparable to perpetual subordinated bonds with the difference that the issue contract provides for redemption.

Classification of bonds by rate

Fixed-rate bonds

They yield the same interest every year. A bond with a "nominal" (capital value) of €2,000 at 11% will yield €220 per year to the investor.

On the other hand, the nominal value will vary according to the interest rates of future bond issues. If the rate of these new bonds increases, the price of the old bonds will fall. The reason for this is quite simple: the new bonds pay a higher interest rate, and investors will only buy the old ones (which pay less) only if they are cheaper. If prices fall, the opposite happens.

These bonds are more intended for investors who want to receive a stable income from their investment, even if it means risking their capital (which can go down as well as up). In times of high inflation, they are unfavourable.

Variable or adjustable-rate bonds

These bonds were introduced to protect the issuer and the holder from the risks associated with fixed-rate bonds:

  • For the issuer: an excessive burden of interest to be paid in the event of a fall in market rates.
  • For the bearer: a fall in prices in the event of a fall in market rates.

The nominal value of these bonds remains unchanged throughout the term of the loan. On the other hand, the interest rate varies according the financial market rates.

Variable-rate bonds

There are three main categories of variable-rate bonds:

  • Bonds indexed to a monetary rate
  • Bonds indexed to a bond rate, e.g. monthly bond market rate or average government bond rate:
    • ln the first case, the interest rate is revised each year based on the average yield of government-guaranteed bonds issued during the past year.
    • In the second case, the interest rate is revised each year according to the arithmetic average of the yields of long-term government bonds.  
  • Bonds based on a hybrid rate formula

Adjustable-rate bonds

The technique consists in remunerating the securities by means of a fixed rate periodically readjusted to the level of the latest monthly bond market rates.

Unlike fixed-rate bonds, variable-rate or adjustable-rate bonds allow investors to focus on capital preservation but make them take risks on the income they wish to earn from this investment. The coupon price may rise or fall over the years. They also protect the investor in times of high inflation.

Bond redemption

Repayment price

The redemption price is the value of the bond at the end of its life. Each bond has a limited life (from 5 to 15 years, although bonds with a maturity of 100 years have already been issued). The redemption price may be higher or lower than the issue price. This difference is called the redemption premium.

The repayment terms

There are three methods of redemption of bonds issued for the issuer:

Redemption in constant annual instalments:

At each period, the bondholder will receive, in addition to the coupon, part of the principal (redemption price of the bond). The total of these two elements, coupon + redemption, will be identical throughout the period. The annuities are said to be constant.

Redemption in equal series:

At each period, the bondholder will receive an identical fraction of the principal. Assuming a life of 5 years, 20% of the principal will be repaid each year. In fact, the amount of interest paid will decrease. 

Bullet repayment:

This method allows the bondholder to guarantee the regularity of the interest paid throughout the life of the bond. Indeed, the entire principal amount is repaid at maturity, i.e. in full on the last day of maturity. Interest is paid throughout the life of the bond.

Bond amortisation

Constant depreciation by equal series

The principal is repaid every year in the same amount. It is customary to divide the amount of the principal by the number of years of repayment to find out the amount of amortisation. Please note! Do not confuse annuity (repayment of principal + interest) and amortisation (only the annual repayment of principal).

Example: Capital of 5000, 5% interest, amortisation in 5 years.

Capital at the beginning of the period Interest Depreciation Annuity Principal at the end of the period
1er 5.000 250 1.000 1.250 4.000
2ème 4.000 200 1.000 1.200 3.000
3ème 3.000 150 1.000 1.150 2.000
4ème 2.000 100 1.000 1.100 1.000
5ème 1.000 50 1.000 1.050 -