A layman’s guide to understanding bonds: Part VII

A layman’s guide to understanding bonds: Part VII

To help you get you head around bonds, Market Index recently launched a series of articles on bonds within an Australian context.

In part I we talked about making sense of bonds, shades of risk, how the bond rate is set, and how long you need to lend your money for.

In part two we looked at the three basic options for having your interest paid, and what happens if you decide to ask for your money back early (aka before maturity).

In part three we looked at the role bonds can potentially play in your portfolio, and why you might buy a bond.

In part IV we looked at the risks of owning bonds.

In part V we look at how bonds have behaved during an abnormally low yield environment.

In part VI we look at how many different types of bonds are out there?

Part VII: Different types of corporate bonds available

Corporate bonds come in all different shapes and sizes, and as such have different terms of structure and risk. Here are the key ones you might find:

Senior bonds: Offer investors the first claim to a company’s assets should it go out of business, ahead of other lenders and shareholders.

Senior secured: Are secured against the issuing company’s property, so if the company goes into administration, you’re higher up the queue than other lenders when it comes to being repaid.

Senior unsecured: While these corporate bonds aren’t secured against the issuing company’s property, you’re still ranked ahead of other unsecured bondholders in the queue to be repaid.

Subordinated: Are the last of all bondholders to have a claim on the issuing company’s assets if it goes out of business. However, they are still ahead of shareholders and other creditors, such as vendors that serve the company.

Investment grade bonds: Are bonds that have been given a credit rating by rating agencies like Standard & Poor’s (S&P), Moody’s and Fitch. They give investors an idea of how risky the bonds are, plus the issuer’s capacity to maintain payments and avoid default.

The best possible rating is AAA from S&P and Fitch and Aaa from Moody’s, indicating that the issuer is extremely likely to meet its financial commitments.

Any rating of BBB- or higher from S&P or Baa3 from Moody’s represents an ‘investment grade’ bond, and suggests the issuer is in a relatively strong financial position.

High-yield bonds: Also referred to as ‘junk’ bonds, they have a lower rating than investment grade bonds, indicating a higher risk of the issuer defaulting on payments.

Junk bonds have a rating of or below BB from S&P and Fitch and Ba from Moody’s and pay a higher rate of interest to reward investors for the higher level of risk.

Zero coupon bonds: Often called dingo bonds in Australia, the issuer has no obligation to make any interest payments during the term of the bond. Only at maturity must the issuer repay the face value of the bond.

Given that investors aren't willing to pay the same amount for a zero-coupon bond that they would for a bond that pays interest, zero coupon bonds are sold at a discount to their face value.

Municipal bonds: Are issued by states, territories or local governments for the same purpose as government bonds, and some of municipal bonds may be tax exempt.

In part VIII, we will conclude our educational series on bond with an insight into Hybrids.