Types of bonds

One bank can issue a bond that is close to riskless and another that can be wiped out completely. In March 2023, as Credit Suisse was rescued by UBS, about CHF 16 billion of its AT1 bonds were written down to zero. Both kinds were “bonds”. The label tells you little; the type tells you a lot.

Every bond from L1.4.01 has the same skeleton: an issuer, a face value, coupons and a maturity. Bonds differ in three ways: who issues them, how the coupon is set, and where the holder stands if things go wrong.

1. Who issues it

• Governments. Sovereign bondsA bond issued by a national government in its own name. are issued by national governments, and each market has its own name: Treasuries in the US, gilts in the UK, Bunds in Germany, JGBs in Japan. A government that borrows in its own currency is usually the safest borrower in that currency, so its bonds set the benchmark for everyone else.
• Other public bodies. SupranationalsAn organisation owned by several governments, such as the World Bank or the European Investment Bank. such as the World Bank, government agencies, and cities or states (US “munis”).
• Companies. Corporate bondsA bond issued by a company. are issued by firms, from utilities to carmakers. They pay more than government bonds because the company might fail (L1.4.07).
• Banks and insurers. Financial firms issue a wide range, from very safe covered bonds to loss-absorbing capital bonds.

2. How the coupon is set

An FRNA floating-rate note: a bond whose coupon resets each period to a benchmark rate plus a fixed spread. pays a benchmark rateA published reference interest rate, such as SOFR in the US, SONIA in the UK or €STR in the euro area. such as SOFR (US), SONIA (UK) or €STR (euro area), plus a spreadThe fixed extra rate an FRN pays on top of its benchmark. fixed at issue. A zero-coupon bondA bond that pays no coupons. It is sold below face value and repays face value at maturity. is the simplest bond of all: one payment at the end. An inflation-linked bondA bond whose face value and coupons are scaled up in line with a price index, so they keep pace with inflation. protects against rising prices: US TIPS, UK index-linked gilts and euro-area linkers all work this way. Its coupon rate is a real rate, the return above inflation (L1.3.07).

3. Where the holder stands in the queue

If an issuer fails, its creditors are paid in order of seniorityA claim's place in the queue for repayment if the issuer fails.. From safest to riskiest:

1. Covered bonds (banks). A covered bondA bank bond backed twice: by the bank itself and by a ring-fenced pool of loans that bondholders can claim if the bank fails. has two layers of protection: a claim on the bank, and a claim on a ring-fenced cover poolThe ring-fenced loans (usually home loans) that back a covered bond. of loans, usually home loans. Germany's Pfandbriefe are the best-known example and date back to the 18th century.
2. Senior secured bonds: securedA claim backed by specific assets the lender can take if the borrower fails. on specific assets the holders can take.
3. Senior unsecured bonds: a general claim on the issuer, with no assets set aside.
4. Subordinated bonds: subordinatedA bond that is repaid only after senior bonds have been paid in full. debt is paid only after senior debt. Banks issue Tier 2 and AT1Additional Tier 1: a perpetual bank bond that can be written down or converted to shares when the bank is in trouble. bonds, which are built to absorb losses.
5. Shareholders come last, behind every bond.

The further down the queue, the more a bond pays, because the holder carries more risk. Try the queue yourself:

Real insolvencies are messier: courts, negotiation and resolution authorities can change the outcome. Strict priority is the starting point.

Options inside a bond

Some bonds carry an option. A callable bondA bond the issuer may repay early, on set dates, at a set price. lets the issuer repay early, which it tends to do when rates fall and it can borrow more cheaply. Investors want a higher yield to compensate. A putable bondA bond the investor may sell back to the issuer early, at a set price. lets the investor sell it back early, which protects the investor, so it yields less. A convertible bondA bond the investor may swap for a set number of the issuer's shares. lets the investor swap it for shares, so it pays a lower coupon in return for a share of the upside. RiskAtoms has models for callable and convertible bonds.

Green and sustainability-linked bonds. A green bond is an ordinary bond whose money is earmarked for environmental projects. A sustainability-linked bond can be spent on anything, but its coupon steps up if the issuer misses targets it has set itself, such as cutting emissions.

Pick a coupon type and change the scenario. Start on the FRN and make rates rise instead of fall, then switch to the fixed bond and see that nothing moves.

Each bond has face value 100 and pays once a year. Try writing out each one's cash flows before revealing them.

Same face value, same maturity, four different streams of cash. The fixed bond's payments are known today; the FRN's depend on future rates; the linker's depend on future inflation; the zero pays once.

Bank capital rules treat some bonds as part of a bank's loss-absorbing capital. AT1 bonds can be written down or converted into shares while the bank is still running; Tier 2 bonds absorb losses if it fails. Their terms are written to meet the Basel rules, covered in L4.1.

Covered bonds sit at the other end. Because of their cover pool, they get lower risk weights in bank capital rules and can count towards a bank's liquidity buffer (L4.2 and L4.5).

• Bonds differ by issuer (government, supranational, corporate, financial), by coupon type and by seniority.
• Fixed bonds pay set coupons; FRNs pay a benchmark plus a spread; zeros pay nothing until maturity; linkers scale with inflation.
• Covered bonds are backed twice, by the bank and by a cover pool. Subordinated and AT1 bonds are paid last among bonds.
• The further down the queue, the higher the coupon investors demand.
• Callable bonds favour the issuer, putable bonds favour the investor, and convertibles can turn into shares.

Sovereign bond

A bond issued by a national government in its own name.

Supranational

An organisation owned by several governments, such as the World Bank or the European Investment Bank.

Corporate bond

A bond issued by a company.

Covered bond

A bank bond backed twice: by the bank itself and by a ring-fenced pool of loans that bondholders can claim if the bank fails.

Cover pool

The ring-fenced loans (usually home loans) that back a covered bond.

FRN

A floating-rate note: a bond whose coupon resets each period to a benchmark rate plus a fixed spread.

Benchmark rate

A published reference interest rate, such as SOFR in the US, SONIA in the UK or €STR in the euro area.

Zero-coupon bond

A bond that pays no coupons. It is sold below face value and repays face value at maturity.

Inflation-linked bond

A bond whose face value and coupons are scaled up in line with a price index, so they keep pace with inflation.

Seniority

A claim's place in the queue for repayment if the issuer fails.

Secured

A claim backed by specific assets the lender can take if the borrower fails.

Subordinated bond

A bond that is repaid only after senior bonds have been paid in full.

Callable bond

A bond the issuer may repay early, on set dates, at a set price.

Putable bond

A bond the investor may sell back to the issuer early, at a set price.

Convertible bond

A bond the investor may swap for a set number of the issuer's shares.

AT1

Additional Tier 1: a perpetual bank bond that can be written down or converted to shares when the bank is in trouble.