Fixed income securities are important to investors portfolios since they provide regular income in the form of coupon payments. However, there are many different types of bonds available in the market which offer different types of coupon payments.
It is important for investors to realize these different types of coupon payments since they can have a huge impact on the monthly cash flow to the investors.
This article describes the common types of coupon rates that are available to fixed income security investors.
- Fixed-Rate: The simplest form of coupon rate offered by bonds is called a fixed-rate bond. These bonds are often called plain vanilla bonds since they are most commonly available in the market. These bonds pay the same nominal interest rate throughout their life.
For instance, if the interest rate is 6%, then the bond will continue to pay 6% throughout the life of the bond regardless of what the interest rate in the market is. Fixed-rate bonds pay interest on a semi-annual basis. However, the interest can also be paid monthly, quarterly, or annually.
- Floating Rate: Floating rate coupon payments bonds are different from regular bonds in the sense that the interest rate is expressed in terms of a benchmark rate. For instance, the interest rate may be expressed as LIBOR plus 2%.
In this case, LIBOR or London Inter-Bank Interest Rate is the benchmark rate whereas the 2% is the premium above the benchmark rate.
LIBOR is the most commonly used benchmark rate for bonds across the world. However, it is also common to use treasury rates of national securities as the benchmark rate. The advantage of floating rates coupon is that it provides protection against inflation. The price of the bonds moves up and down in tandem with the interest rates. Hence, the real rate of return remains the same for investors.
- Zero-Coupon: Zero-coupon bonds are another variation of coupon rates, which are mostly offered by government agencies. As the name suggests, these bonds do not pay any coupon throughout the life of the bond. This means that the bonds are first sold at a deep discount to their face value.
Lets understand this with the help of an example. A treasury bond with a face value of $100 and a maturity of five years, could be sold at $60. Hence, the investor has to pay $60 during the start of their investment, and then they would receive $100 at the end.
During the time period of the investment, the interest would accrue to the bond and would also reflect in its market price. However, there would not be any actual payments, semi-annual or otherwise. Even though these bonds dont pay any coupon, their implied coupon rate is calculated in the form of a semi-annual rate. This is done in order to make these bonds comparable with other bonds in the market.
- Step Up Coupon: Step-up coupon rates are used by firms that do not have adequate cash flow immediately. However, they foresee a major increase in the amount of cash flow in the near future.
Step up coupons start with a low-interest rate. However, the coupon interest rate increases every year.
For instance, a step-up coupon bond may start with a 6% interest rate. However, in the forthcoming years, the interest rate may increase by one percentage point each year. These bonds are useful to the company as they incentivize investors to hold on for longer periods of time.
In the initial few years, the interest accrued is less. However, this changes drastically with the passage of time.
Start-up companies find this useful since investors are not constantly trying to sell their bonds in the market. As a result, they do not have to face the pressure immediately. There are many types of step-up bonds. Some of them are structured to increase with the same rate whereas others are structured in such a way that the coupons increase at a growing rate.
- Credit Linked Coupon: Credit profile linked coupon rates are also common in the market. These types of bonds incentivize companies to maintain a good credit profile. This is because if their credit profile goes down i.e. if they receive a negative credit rating from professional rating agencies, then their coupon payments also increase.
On the other hand, if a company is able to improve its credit rating, the payments reduce as per an agreed-upon schedule.
The advantage of these types of bonds is that the covenants are typically not very restrictive. Companies can choose whether or not they want to extend their credit temporarily. If they want to raise funds temporarily, they could do so by extending their credit and paying a higher interest rate.
The fact of the matter is that investors get a wide variety of options. They can choose from different types of cash flows depending upon their personal risk factors as well as their time preference of money.