Fixed-income securities generally refer to bonds that pay a fixed rate of interest. We are referring here to 'special bonds'. These are bonds with special characteristics and conditions. As a result, these bonds present different risks to ordinary bonds.
We will look here at six types of special bonds:
High-yield bonds are bonds with a relatively low rating from BB to D. Given their low credit rating and the higher risk associated with that, these bonds offer a relatively high return. This higher risk means there is a greater chance that the payment of interest and repayment of the principal will not take place.
Inflation-linked bonds, or so-called index-linked bonds, offer less risk because they offer protection against inflation. This is because their interest, yields and redemption are linked to this. The higher the inflation rate, the higher the interest rate. The payments (coupons) are also indexed on the basis of a defined consumer price index. The coupon is generally lower than an ordinary bond, given the reduction in the risk of the investment. These bonds may be unattractive in periods of low inflation or deflation, and generally have a longer term to maturity.
A subordinated bond involves more risks than an ordinary bond. As such, you usually receive more interest on subordinated bonds than on ordinary bonds. If the company (or the country) that issued the bond goes bankrupt, however, you will end up at the back of the queue of creditors (though ahead of the shareholders) and you will only be paid out once all other creditors have been satisfied. Perpetual bonds are often subordinated.
Just like a normal bond, a company may issue a convertible bond to raise money for new investments, for example. And just like a traditional bond, it has a fixed coupon and a fixed term. But with a convertible bond, you as a bondholder have the right (though no obligation) to exchange (convert) the bond for a predefined number of shares of that company at a predetermined price (the conversion price) within a period fixed in advance (the conversion period). This right is comparable to the rights of a call option. As a result of this right, the coupon rate of a convertible bond is usually lower than the coupon rate of a comparable ordinary bond.
Bond value and conversion value
A convertible bond therefore has the characteristics of both a bond and a share. Since the prices of both the convertible bond and of the relevant share on the stock exchange are subject to fluctuations, the conversion price needs to be calculated regularly. A convertible bond therefore has two types of value:
For convertible bonds, the liquidity risk may be greater than for a traditional bond, since the secondary market for them is generally limited. Moreover, the price risk is significant as the price of the convertible bond closely tracks the price of the share. However, the interest rate risk is limited, as the interest rate is generally much lower than that of an ordinary bond.
A perpetual bond is also known as a consol bond, and is a bond without a maturity date. This means that you do not know when you will receive your money back. The issuing institution usually has the option of repaying the perpetual bond early, at predetermined times and at a price that is fixed in advance. However, whether or not it actually does so depends on the conditions agreed when the perpetual bond was issued, and on the situation on the stock market. The issuing institution may also decide to skip the interest payment in a given year, which is called passing. Perpetual bonds offer you a higher coupon rate than comparable ordinary bonds, which is in return for the uncertainty about whether you will receive all the interest and when you will get your money back. The price of a perpetual bond also reacts more strongly to a change in interest rates than an ordinary bond. The price volatility – and therefore the risk of losses – is higher than for a traditional bond. The calls that are usually built in can also be considered a risk for the investor, since the issuer usually exercises these when they see an opportunity of refinancing at a more favourable price.
Asset-backed securities are bonds where the coupon rate and redemption of the bond are based on collateral of pools of different types of lending. These include pools of mortgages and vehicle financing, for example. Asset-backed securities are also referred to as repackaged loans. The issuing institutions can issue the underlying packages in a number of tranches (slices), and each tranche has its own credit risk.
Investing in asset-backed securities is risky, as it is often unclear exactly what the collateral consists of. It is also difficult to estimate the level of risk of large groups of people not being able to repay their mortgages or loans. This makes the credit risk of asset-backed securities much less transparent than the credit risk of an ordinary bond, where the credit risk only means the risk that the issuing institution cannot repay the bond.
Asset-backed securities were one of the biggest causes of the US credit crisis in 2007, with the collateral consisting mainly of variable rate mortgages. When the mortgage rate rose rapidly, many US citizens were unable to cover the higher interest rate on their mortgage, or even unable to repay the mortgage as a whole. As a result, asset-backed securities quickly lost their value or were left with very little value.
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