Bonds: Categorisation by type

The segmentation of bonds creates transparency and helps investors through the jungle of designations. Important differences include the interest rate, type of issuer, structure and rank.

Type of interest calculation

Depending on the type of interest, a distinction is made between classic bonds, zero coupon bonds and bonds with coupon interest.

• Classic bonds with fixed, regular interest rates
  Most bonds have a fixed coupon. This means that they have a constant interest rate and a constant interest income until maturity. Interest is usually paid annually. 
   
• Bonds with variable interest rates (floaters)
  The interest rate for this type of bond is determined by the issuer after each interest period. The interest rate is usually based on certain reference interest rates at which banks invest funds at short notice with other banks. The formation options for variable-rate bonds are very wide. However, you can specify upper and lower limits for the interest rate. Investors should obtain precise information about the interest rate before buying bonds with variable interest rates.
   
• Zero coupon bonds
  In the case of zero coupon bonds, investors do not receive fixed interest payments. In return, zero-coupon bonds are issued well below their nominal value. At maturity, they are redeemed by the issuer at nominal value. The income is calculated from the difference between the issue price and the nominal value. This means that the total return is accrued once at the end of the term. Zero coupon bonds are allocated to the category 'Other bonds' on the Frankfurt Stock Exchange.
   
• Low-interest bonds
  The bond type has a lower interest coupon, but these bonds are issued below the nominal value. Investors usually invest in these bonds for tax reasons.

Different issuers

Bonds can also be classified according to the type of issuer of the bond. There are government issuers and private issuers.

• German Government securities
  To finance their capital requirements, the Federal Republic, federal states, cities and municipalities issue various bonds. The Federal Government issues securities that can be traded on the stock exchange in addition to Federal bonds (term between ten and 30 years), Federal notes (term about five years) and Federal treasury notes (term about two years). Their respective conditions are important orientation parameters for the entire capital market. Bunds are issued in a so-called tender procedure, similar to an auction, via the Bidder Group Bund Issues and issued or increased several times a year. Immediately after the issue, German government bonds are launched for trading on the Frankfurt Stock Exchange.
   
• Euro government bonds
  Like the Federal Republic of Germany, other states, municipalities or cities also issue bonds to cover their capital requirements. Bonds issued by government issuers within the euro zone are referred to as euro government bonds. The creditworthiness of most euro countries is comparable to that of the Federal Republic of Germany, with yields deviating only slightly from the yields on government bonds.
   
• Government bonds of other countries
  The central banks of many other countries issue bonds. Here, a distinction is made between issues by industrialized countries and emerging market bonds. Countries that are on the threshold from underdeveloped countries to industrial nations have a large capital requirement, which they explicitly cover abroad. These include Argentina, Russia, Brazil, India or China. Emerging market bonds are mainly denominated in euros or US dollars. Their attractiveness lies in the high interest rates they pay their lenders. The risk of this bond class lies in the poor creditworthiness of the respective countries and the economic development, which cannot be assessed on this basis.
   
• Corporate bonds
  Companies often take advantage of the opportunity to finance themselves through corporate bonds instead of bank loans. The coupon on issue or later the yield on corporate bonds depends on the creditworthiness of the company. The worse the rating, the higher the interest or yield. As a result, you have to reckon with the so-called corporates in the event of a change in the rating with price changes. Like equities, corporate bonds can react very sensitively to macroeconomic changes. In contrast to Pfandbriefe, corporate bonds are effectivly subordinated compared to many other forms of dept. This means that if the company can no longer service its debt, other creditors are paid before the bond owners.
   
• Pfandbriefe from banks
  Banks lend to private and corporate customers. They obtain the necessary capital by issuing bonds. A special form of this bank bond is the Pfandbrief. Pfandbriefe are subject to strict legal regulations regarding the use of loans and the liability of issuers. The loans included in Pfandbriefe may only be used to finance real estate and houses. The loans are secured. The financed real estate and land serve as collateral.
   
• Jumbo Pfandbriefe
  Pfandbriefe were generally bought by investors and held to maturity, with hardly any trading taking place. In order to boost Pfandbrief trading and make this type of bond more attractive for foreign investors as well, Jumbo Pfandbriefe, or Jumbos for short, were introduced in 1997. Jumbos combine several small issues into one large issue. Jumbo Pfandbriefe must meet the following conditions: the issue volume must be at least 1 billion euros, they can only be increased by at least 125 million euros. At least five Market Makers provide at the usual from 9 to 17 o'clock simultaneously bid and ask prices up to an order volume of 15 million euro.

Differentiation according to other specific features

• Foreign currency bonds
  This category includes all bonds not issued in euro, whether issued by public or private issuers. Both bonds in leading currencies such as the US dollar or pound and, for example, the South African rand belong in this category. The attraction of foreign currency bonds lies in the possibility of higher interest rates compared with the euro zone and in the chance of a exchange rate gain. However, there is also the risk of a exchange rate loss against the euro.

• Participation certificates
  Profit participation certificates are non-standardized securities and represent a hybrid form between shares and bonds. Profit participation capital belongs to the liable equity capital of a company; however, in contrast to shareholders, holders of profit participation certificates do not have voting rights. On the other hand, these securities securitize creditor rights and holders of the certificates receive interest on their capital – higher than with a classic corporate bond. The distribution is usually linked to the economic situation of the company. After a good financial year, the payout can be increased; in bad times, it can be completely cancelled in the worst case. In the case of listed companies, the shareholders decide on the amount of the distribution at the Annual General Meeting. Since the structure of this class of securities is not prescribed by law or the stock exchanges, there are many different forms of participation certificates.

Other types of bonds

• Subordinated bonds
  Subordinated bonds, also known as TIER1 bonds, are usually offered by banks. Subordinated means that if the issuer defaults, all other liabilities of the bank are first satisfied before the bond holders receive their money. Classic TIER1 bonds have an infinite maturity. The issuer pays interest on the bond only if the bank also pays a dividend. Because of the higher risk, the interest rates are higher than for comparable senior bonds. There are now also subordinated corporate bonds. TIER stands for the English term level, the term TIER1 comes from logistics. 

• Convertible bonds and warrant-linked bonds
  Convertible bonds and bonds with warrants may be issued by stock corporations. Both are fixed-interest securities that give investors the right to exchange them for shares or exercise their options. In the case of convertible bonds, the holders can exchange their bonds for shares in the company during the term of the bond. If the conversion right is exercised, the bond expires. Option bonds are interest-bearing securities that give the investor the right to acquire shares or other fungible (tradable) assets in a warrant that can be separated from the bond. Once issued, the option can be traded separately from the bond. Option and convertible bonds are an inexpensive way for companies to raise capital. Issuers reduce the market interest they would normally have to pay their investors. In return, they sweeten the lower (interest) income with the right to buy the company's share at a predetermined price.

• Structured bonds
  Fixed-income securities also include structured bonds. On the surface, they function like a normal bond with a fixed interest rate. However, structured bonds have individual additional conditions. This can affect the interest conditions, i.e. the coupon increases or decreases in fixed steps or the bond changes into a floater after a certain period of time. However, special repayment conditions also make a fixed-interest security a structured bond, as is the case with credit-linked notes. In this type of security, the issuer securitises a loan it has granted to a third company. If this debtor defaults, the bond owner is liable for the outstanding loan in the amount of his bond. Investors should obtain very detailed information about the interest and redemption terms of the structured bond.

• Inflation-linked bond
  In the case of inflation-linked bonds, the coupon and redemption amount are linked to inflation. This protects them (in part) from inflation. Price indices are regarded as the benchmark index. In the case of inflation-linked government bonds, this is the harmonised consumer price index (HICP) excluding tobacco. The HICP measures the price level of goods and services paid by households in the euro area. The so-called index ratio is used to calculate the inflation-dependent coupon and the redemption. This is the ratio between the value of the Benchmark Index on the settlement date and its level at the time the bond was issued. If inflation rises, this has a positive effect on interest rates and the amount at the end of the term. In the case of low inflation or even deflation, however, interest income is lower than for conventional bonds. The federal inflation-linked bonds are repaid at face value in the event of deflation.

© May 2019 Deutsche Börse