Capital Market Securities - Bonds (Part 2)

Welcome back to my ongoing series on finance! Writing on bonds was more complicated than I expected, and I learned a lot writing about it! Hope you learn a lot from this too!

In my previous article on bonds, we explored what a bond is, their ratings and how one may hold a bond. There’s more to bonds than that however, bonds also came in many variations, from what they’re backed with (or supported by) to the varying rights they grant a bondholder. 

Bonds by collateral

A major attribute if a bond is the security, collateral or assets that are pledged to back the bond issue. It’s like if you took your friend’s phone for security when he takes a $1000 loan from you. A bond can either be secured (a mortgage bond) or unsecured ( a debenture bond). 

Bonds can be backed by various properties

Mortgage bonds are backed by property pledged by the issuer (not quite the same as a bond backed by someone’s home mortgage). This property can be real estate, buildings, or even movable assets (like railroad cars or aeroplanes)! In the event of a default, bondholders would have a right to money from selling these pledged properties. 

When backing a bond with property, an important consideration is whether the property will be just for that bond, or can back multiple bonds. This is, for bonds, is described as being closed-end or open-end. 

A closed-end mortgage bond locks up the pledged assets, so the assets cannot be pledged to another bond issue. It would mean that, following the phone example above, your friend would need to pass you another phone to borrow another $1000 from you.

An open-end mortgage bond is the opposite, in which the pledged assets can be re-pledged for another bond issue. This would be akin to allowing your friend to borrow another $1000 without passing you another phone to hold on to. Not quite as safe a decision as requiring another phone for another loan!

One might observe that closed-end mortgage bonds have a lower risk than open-end mortgage bonds, since the pledged property is exclusively pledged for that bond. That is why open-end mortgage bonds usually mitigate their risk by requiring the issuer to pledge additional property subsequently it obtains to the open-end mortgage bond. 

Debenture bonds (not backed by property)

Debenture bonds are unsecured obligations (there is no collateral backing them) and depend on the financial strength of the issuer for their security. It would be the same as lending $1000 to a friend and relying only on his promise to pay you back. Similarly, debenture bondholders fall under general creditors and would not have priority over any specific property to recoup their losses in the event of a default.

Under debenture bonds, there is a class of bond known as a subordinated debenture. These bondholders have an even lower priority than normal debenture bondholders in the event of a default. Why would they then hold such bonds? Because they have a higher interest rate to accompany the risk.

Bonds by rights

Bonds may also be categorised by the rights available to the issuer and the bondholder. Generally speaking, the different kinds of bonds by rights are:

• Straight bonds
• Convertible bonds
• Callable bonds
• Putable bonds
• Extendable notes
• Zero income bonds

Straight bonds are the simplest bonds. It will pay out its interest at set timings, and make its last payment when it matures.

Convertible bonds are bonds that can be converted into shares of the bond issuer when the bondholder wishes. This is usually set at a specified number of shares (Bond A can be converted into 100 shares, for example) and set at a price that is unfavourable so that the bondholder does not immediately convert the bond to shares. If the share prices go up enough however, then it may become a better deal to convert the bond into shares. 

Callable bonds are bonds which allows the issuer to redeem the bond before the set time of maturity. The issuer will pay the bond’s interest and principal amount to fully redeem the bond. Companies may wish to do this reduce its debt or to replace its debt with lower interest debt (if they can obtain lower interest debt due to the financial environment)

Putable bonds are callable bonds for the bondholder. Bondholders may force the issuer to redeem the bond before the set maturity date. This is typically caveated, however, such that bondholders may only “put” the bond on particular dates or certain events (such as on the downgrading of the bond’s rating). Putable bonds offer extra protection to the bondholder, and typically have lower interest rates. 

Extendable notes are bonds which have their interest rates reset at regular intervals to reflect the interest rate environment and any changes in the issuer’s credit quality. Typically, bondholders will have the option to accept the interest rate or to “put” the bonds back to the issuer. 

Zero income bonds are bonds which pay no interest over the life of the bond. These bonds are typically sold at a discount from the par value. The bondholder then makes money by being paid more money at the time of maturity than the bond was bought for (instead of through those regular interest payments). 

And that’s it for bonds! Next week we’re looking at stocks, which is probably the most well-known capital market security!