Investors know there are different types of bonds, but they may not be aware of just how many different types of bonds there are. Let’s go beyond plain government and corporate issues to cover some of the more specialized types of bonds available in the fixed income market.
Inflation-Protected or Real Return Bonds
These bonds are designed to protect investors from inflation by preserving their purchasing power with cash flows that keep pace with the cost of living, regardless of interest rates or inflation. Their returns are tied to the level of prices, based on consumer price index (CPI) levels.
In the U.S., they’re called Treasury Inflation-Protected Securities (TIPS), while in Canada, they’re known as Real Return Bonds (RRBs).
With RRBs, the face value and interest payments are pegged to CPI and adjusted periodically over the life of the bond. The principal is increased to offset the impact of rising inflation, based on CPI readings. The market value of RRBs is continually adjusted for changes in the CPI, while the principal is reset semi-annually.
With TIPS, as inflation rises, rather than the yield increasing, the price (or principal amount) is adjusted upward to maintain their real value. The principal rises as inflation rises, while the interest payment varies with the adjusted principal value of the bond. At maturity, TIPS pay the inflation-adjusted principal or original principal, whichever is greater.
With inflation-linked bonds the outstanding principal increases as inflation rises. So, the face or par value of the bond increases when inflation occurs. This is in contrast to other types of fixed income securities, which tend to decrease in value as inflation mounts.
They are typically long maturities with some RRBs extending over 20 years, while the U.S. Treasury currently issues 5, 10, and 30-year TIPS. This is because they were designed to protect against inflation over the long term rather than provide a short-term hedge against rising prices.
Their returns don’t correlate highly with those of stocks or other fixed income assets, meaning they are good diversification enhancers to help investors mitigate volatility.
Floating Rate Notes
Floating rate notes (FRNs) are debt instruments with a variable interest rate designed to protect against rising rates, as FRN holders benefit by receiving higher coupon payments when interest rates increase. That being said, floaters might underperform if short-term rates decline or remain unchanged.
FRN reference rates are tied to a benchmark interest rate, such as the Canadian Dealer Offered Rate (CDOR), the Federal Reserve’s Federal Funds Rate, the London Interbank Offered Rate (LIBOR), or other national prime rate.
Coupons are adjusted on a monthly or quarterly basis and because of this reset, floaters have very low duration. The length of time to the next coupon reset is the extent of duration risk with floaters, which makes them especially attractive during periods of rising interest rates.
Floating rate notes are issued by financial institutions, governments and their agencies, as well as corporations, and generally have maturities between two and five years.
Floaters typically offer a lower yield at issuance versus comparable fixed coupon bonds — in exchange for the additional security of receiving more coupon interest as the benchmark rate rises and also because they are benchmarked to short-term rates.
The downfall with floaters is that if the benchmark falls, so too will the rate on the FRN. Investors are also exposed to default and credit risk on any non-government issues.
Floaters tend to exhibit less volatility, or price fluctuation, than traditional bonds. While they can certainly help mitigate some risks during periods of rising rates, to mitigate is not the same as to eliminate.
Foreign and Global Bonds
Countries and companies all over the world issue bonds and these bonds are often held for diversification purposes. But, they are also appealing when foreign rates are higher than the rates in an investor’s home country, as it could lead to earning higher interest rates if yields are more attractive in other countries.
They also give bondholders exposure to sectors that are not well represented domestically and reduce the degree of exposure to the actions of any one central bank.
A foreign bond is issued by a company or government agency in one country, but offered to investors in other countries in those currencies. Maple (Canada), Samurai (Japan), Yankee (U.S.), Bulldog (U.K.), and Matilda (AUS) bonds are some examples of foreign bonds.
A global bond is issued in multiple countries at the same time and usually by a large multinational corporation or sovereign entity with a high credit rating.
Investing in these types of bonds involves multiple risks, so they typically offer higher yields versus domestic bonds. There are implicit and explicit risks associated with foreign and global bonds, including the impact of multiple interest rates, currency exchange rates, inflation rates, and geopolitical tensions.
Currency fluctuations add volatility to a bond portfolio relative to one invested solely in domestic bonds. Investors can access unhedged funds that are fully exposed to currency fluctuations while hedged funds are protected through the use of currency forwards, which lock in exchange rates.
Zero Interest or Strip Bonds
Strip bonds are a hybrid fixed income investment created when a standard bond is disassembled into its component parts. The principal and coupon payments are removed or “stripped” away from the original bond by an entity other than the issuer and sold separately to investors.
The act of stripping a bond produces two new investment assets; the residual strip bond and a strip of all future coupon payments. Both are considered strips and do not pay regular interest payments, which means there is no reinvestment risk.
The stripped bond principal is referred to as the residual, which is sold at a discount and becomes a zero-coupon bond with investors receiving an amount equal to the face value of the bond at maturity.
The longer the term to maturity, the deeper the discount. The difference between the purchase price and face value equals the interest income.
The duration of zero-coupon bonds will equal their term to maturity, which means their prices are more volatile than those of conventional bonds. But, this will not be of much concern for investors who plan to hold until maturity, which can range from months to 30 years.
They also come in all manner of sizes, from thousands up to millions of dollars. Investment dealers will sometimes split up larger bond issues to sell the stripped components in smaller lots.
There are many high-quality strip bonds available from issuers like the Government of Canada and provincial governments, as well as banks and corporations.
Some of the key benefits of zero-coupon bonds include their known and fixed yield, based on the set maturity date and ability to buy at a discount as well as the liquidity that comes from strips being actively traded.
Because of the prescribed tax treatment investors would be wise to own zero-interest bonds in tax-deferred and tax-sheltered plans like an RRSP, RRIF, TFSA or RESP.
AT1 Bonds
Additional Tier 1 Capital (AT1) bonds are part of a family of bank capital securities known as contingent convertibles or “CoCos”. They were introduced in 2013 in Europe, and are also known as Limited Recourse Capital Notes (LRCNs) in Canada.
Banks use these bonds to augment their core equity base to comply with Basel III requirements. AT1 bonds were introduced after the global financial crisis, to protect depositors.
AT1 bonds are unsecured, long-dated hybrid securities meant to enhance banks’ core capital base. They sit one rung above common equity in the capital stack, below a bank’s subordinated debt, and alongside preferred shares in the capital stack. While AT1 bonds offer higher yields than higher-quality bank senior and subordinated debt, they also present some unique risks.
Since they make up part of the capital cushion that regulators require banks to maintain to provide support in times of turmoil or distress, AT1 bonds are the first to take losses in any sort of crisis. If a bank’s capital levels fall below a certain threshold, this can trigger them being converted into equity or written off, as was done with the Credit Suisse AT1 bonds during the spring 2023 banking crisis.
If AT1s are converted into equity, this supports a bank’s balance sheet and helps it to stay afloat. They also pave the way for a “bail-in,” or a way for banks to transfer risks to investors and away from taxpayers, if there’s trouble.
AT1 bonds do not have a maturity date so are perpetual in nature and they can only be sold to institutional investors.
These bonds are tradable and expected (but not always required) to make regular coupon payments. Coupon payments are non-cumulative and discretionary and these are not considered defaults or credit events.
Public/Private Partnership (or P3 Bonds)
Public-private-partnerships are formally described as “long term contractual arrangements between the government and a private partner whereby the latter delivers and funds public services using a capital asset, sharing the associated risks,” by the Organisation for Economic Co-operation and Development (OECD).
Public-private partnerships involve collaboration between a government agency and a private-sector company that’s used to finance, build, and operate projects, such as public transportation networks, parks, hospitals and convention centres. Highway 407 in Ontario is one example. P3 bonds are primarily used for infrastructure projects.
A P3 typically involves a private entity financing, constructing, and/or managing a project in return for a promised stream of payments directly from government or indirectly from users over the projected life of the project or some other specified time period.
Most of the up-front financing is made through the private sector, but this financing can differ significantly by country. For P3s in the U.K., bonds are used rather than bank loans. In Canada, P3 projects typically use loans that are to be repaid within five years, and the projects get refinanced at a later date. In some types of public-private partnership, the cost of using the service is borne exclusively by the users of the service — for example, toll road users.
P3s enable the public sector to harness the expertise and efficiencies that the private sector can bring to the delivery of certain facilities and services traditionally procured and delivered by the public sector.
P3s offer investment-grade security with the higher yields of junk bonds. They typically have contract periods of 20 to 30 years or longer and usually amortize the principal, so it’s repaid gradually rather than waiting for the bond to mature.
Public-private partnerships are most common in transport and municipal or environmental infrastructure and public service accommodations.
Knowledge is power
Investors may never need these kinds of bonds in their portfolios, but it’s always helpful to know what’s out there in case they decide to go beyond traditional bonds.
