Deep Dive into Various Types of Bonds

1Learning roadmap

A bond is a contract for borrowing money. To understand any bond, ask: who owes you, what cash flows are promised, when principal comes back, and who can change those payments? This guide builds those questions around a ₹1,000 investment.

By the end, you should be able to classify bonds along several dimensions, draw their cash flows, compare embedded options, and explain why a higher coupon is not automatically a better return. Examples are hypothetical, before fees and taxes; they are not current offers.

2Bond anatomy and the running example

3One bond can have many labels

Bond categories overlap. “Corporate” describes the issuer; “floating-rate” describes the coupon; “secured” describes collateral; “callable” describes an issuer option. None excludes the others.

4Government and public-sector bonds

Sovereign bonds are issued by national governments. State and local authorities also borrow; supranational institutions issue debt backed by their own financial structures. Credit quality depends on the actual obligor, currency and legal terms. Public ownership alone is not an explicit government guarantee.

For Indian market terminology, see the RBI government-securities primer.

General obligation, revenue and agency debt

An association with government does not make every agency security sovereign-guaranteed. Municipal structures and tax rules also differ across countries. A project’s revenue covenant can require tariffs sufficient to maintain an agreed debt-service coverage ratio.

5Corporate credit, security and seniority

Corporate bondholders lend to a company; shareholders own a residual interest. Interest and principal remain subject to the issuer’s capacity and contractual obligations. Ratings summarise a credit opinion; they do not guarantee repayment or liquidity.

Terms such as “debenture” vary across jurisdictions. Read the security documents rather than inferring collateral from the name. See Investor.gov’s corporate-bond overview.

Covenants: what the borrower must do

Incurrence and maintenance describe when a test applies; affirmative and negative describe the obligation’s nature. Covenant packages vary by transaction. Do not assume every investment-grade or high-yield bond contains the same protections.

Payment-in-kind interest

PIK interest is added to debt or paid in additional securities instead of cash, according to the terms. A $1,000 balance with 8% annual capitalised PIK becomes $1,080 after one year and $1,166.40 after two. The growing claim does not provide current cash or ensure eventual recovery.

6Fixed-rate bonds

The coupon rate remains unchanged under the contract. With a bullet structure, principal is returned at maturity. A stable coupon fixes scheduled income, not the resale price or purchasing power.

For unchanged promised cash flows, a higher required yield implies a lower present value. Longer maturities and lower coupons generally increase interest-rate sensitivity, other things equal. Coupon receipts also create reinvestment risk.

7Zero-coupon bonds and STRIPS

A zero-coupon bond makes no periodic coupon payments. Its return comes from the difference between the purchase price and redemption amount, provided the issuer pays. STRIPS separate eligible bond coupons and principal into individually tradable zero-coupon claims.

A zero avoids interim coupon reinvestment but can be highly price-sensitive before maturity. Tax treatment may recognise income before cash receipt, depending on jurisdiction. TreasuryDirect explains marketable securities and STRIPS.

8Floating-rate notes and step-up bonds

A floating-rate coupon resets using a specified benchmark plus a contractual spread. The benchmark, fixing date, reset frequency, payment lag, day-count basis, cap and floor determine the payment. A step-up bond instead changes its coupon according to a predefined schedule or trigger.

Frequent resetting often reduces sensitivity to the benchmark rate, but credit-spread changes, caps, floors and liquidity can still move the price. Floating-rate does not mean capital-protected.

9Inflation-linked bonds

Inflation-linked bonds tie principal or payments to a specified price index. US TIPS apply a fixed coupon rate to inflation-adjusted principal. The index, lag and any redemption floor matter; structures differ by country.

For US TIPS, maturity redemption is the greater of adjusted principal and original principal. This does not guarantee recovery of a premium paid in the secondary market. Their prices can fall when real yields rise. Source: TreasuryDirect, TIPS.

10Bullet, amortising and sinking-fund bonds

A bullet returns principal at final maturity. An amortising bond returns some principal along the way, reducing the balance on which interest is charged. A sinking-fund provision requires scheduled retirement or funding arrangements under the indenture; individual holders may be affected differently.

11Callable bonds: the issuer’s option

A call provision lets the issuer redeem under specified conditions, often after a protection period and at a specified price. When refinancing becomes cheaper, a call may be attractive to the issuer, leaving investors to reinvest at lower rates.

For otherwise comparable instruments, callable value = option-free bond value − issuer call value. Price upside can be limited as the call becomes likely. Make-whole calls use different compensation mechanics. Compare relevant yields to call and maturity; yield to worst is a contractual yield scenario, not protection against default. Source: Investor.gov, callable bonds.

12Puttable and convertible bonds

A put gives the holder a right to demand redemption on stated terms. A conversion right permits exchange into shares using a defined ratio, sometimes subject to issuer actions or mandatory conversion provisions.

For a comparable simple puttable bond, value = straight-bond value + holder put value. The issuer must still be able to honour the put.

13Perpetuals, hybrids and contingent capital

A perpetual has no scheduled final maturity. Some hybrids allow coupon deferral, cancellation or loss absorption. Bank regulatory-capital instruments can contain write-down or conversion triggers and subordinated ranking. The precise contractual and regulatory terms dominate the familiar word “bond”.

A first call date is not a maturity promise. Do not treat perpetual capital as a deposit or assume a missed coupon always has the same default consequence as on ordinary senior debt.

14Securitised bonds: ABS and MBS

Asset-backed securities draw payments from pools such as auto loans or receivables. Mortgage-backed securities are supported by mortgage cash flows. A waterfall allocates payments and losses across claims or tranches; guarantees and legal structures vary.

A senior tranche is protected by structural subordination only to the extent provided by the deal. Collateral losses, correlation, servicing and the waterfall still need analysis.

15Currency, international markets and labelled bonds

Currency is a separate risk dimension. An investor’s home-currency return depends on both the bond return and the exchange rate. Foreign bonds are issued by foreign borrowers in a domestic market under that market’s framework; Eurobonds are international issues outside the domestic market of their currency and need not be denominated in euros.

Green, social and sustainability bonds typically describe eligible use of proceeds. Sustainability-linked bonds tie financial terms to stated performance targets. These labels do not by themselves establish seniority, collateral or a repayment guarantee.

16Compare the structures

Credit ratings, spreads and expected loss

The usual long-term investment-grade boundary is BBB− for S&P/Fitch and Baa3 for Moody’s; BB+/Ba1 begins speculative grade. Ratings express opinions, and agency definitions are not identical. A rating does not determine a unique spread or default probability.

A credit spread compensates for more than expected default loss: liquidity, uncertainty, risk premiums, maturity and options can contribute. A simple yield difference requires comparable maturity and conventions. An option-adjusted spread uses a model to account for embedded options; its value depends on that model.

The PD and recovery in this example are workbook scenario assumptions, not current market estimates or verified historical averages. Expected loss is an average across possible outcomes, not a forecast of the actual loss on one bond. Seniority, collateral, jurisdiction and the enterprise structure affect recoveries.

For the workbook’s four equal-$10 million exposures, the assumed PD/LGD pairs are 0.08%/27.5%, 0.35%/56.5%, 2.10%/56.5% and 7.80%/69.0%. Their expected losses are $2,200, $19,775, $118,650 and $538,200: total $678,825, or 1.6971% of $40 million. Add exposure-level expected losses; multiplying separate average PD and average LGD generally gives a different answer.

Tax and liquidity comparisons

Tax outcomes depend on the security, investor and jurisdiction. If a hypothetical 3.5% yield is entirely exempt from the tax being compared and the alternative is taxed at 30%, its taxable-equivalent yield is 3.5% / (1 − 30%) = 5.00%. This simple comparison assumes otherwise comparable risk and ignores other taxes. No municipal, supranational or sustainable label establishes universal tax exemption.

For liquidity, inspect actual trading frequency, issue size, bid–ask spread and available size at quoted prices. A broad label such as “investment grade” does not guarantee an easy exit during market stress.

17Interactive cash-flow laboratory

Compare a fixed bullet, zero-coupon and equal-principal amortising structure. Change coupon, maturity and required yield. All calculations use annual periods, ₹1,000 face value, settlement at time zero, no accrued interest, no fees, no default and no embedded options. The zero-coupon choice ignores the coupon input.

Workbook case: compare five $1,000 structures

This separate classroom case preserves the workbook’s dollar units and 5% assumptions. The rupee calculator above remains an independent exercise. Bullet and amortising coupons are 5%; the zero is purchased at a 5% annual yield. The floating note uses annual illustrative benchmark fixings of 4.00%, 4.50%, 3.50%, 3.00% and 3.25%, plus 1.50%. The indexed bond uses a 2% real coupon and constant 3% annual inflation.

The three 5%-IRR structures have different total dollar gains because their investment amounts and capital-return timing differ. Total receipts are not comparable annual returns. The floating IRR is conditional on the assumed future fixings; the arithmetic average coupon is 5.15% and is not the IRR.

For the indexed example, year-5 principal is $1,000 × 1.03⁵ = $1,159.27. The model’s nominal return is (1.02 × 1.03) − 1 = 5.06%. These annual schedules are simplified teaching models. Actual US TIPS pay semiannually and use their contractual indexation conventions; actual FRNs follow their own fixing, accrual and reset terms.

18Formula sheet and Excel blueprint

For a cash-flow worksheet, place years 1–5 in A2:A6, opening principal in B2:B6, interest in C2:C6 and principal repayments in D2:D6. Set E2 = C2+D2 and F2 = E2/(1+$H$1)^A2, then fill down. Put the annual yield in H1 and sum F2:F6. For equal-principal amortisation, principal repayment is ₹200 a year; reduce the next opening balance accordingly.

YTM is an internal rate of return on promised cash flows. Achieving the same compounded terminal return also depends on reinvestment at that yield and receiving all payments. Use actual date and day-count conventions for real instruments.

Workbook extension: price, duration and convexity

Use $1,000 face, a 5.5% annual coupon, ten years, semiannual payments and a 5.0% nominal annual yield compounded semiannually. Assume settlement on a coupon date with no accrued interest. There are 20 periods, each coupon is $27.50, and the periodic discount rate is 2.5%.

Calculate these from the same discounted cash flows. With period k, frequency m = 2 and price P: D_Mac = Σ[(k/m) × CF_k/(1+y/m)^k]/P. Convexity = Σ[k(k+1) × CF_k/(1+y/m)^k+2]/(P m²). For a small yield change, ΔP/P ≈ −D_modΔy + ½ Convexity × (Δy)².

Keep annual rates, periodic rates, number of periods and time in years consistent. Between coupon dates, accrued interest and the market’s day-count convention must be handled separately. A simple regular-period PV expression alone does not determine a settlement-date clean price.

19Knowledge check and common errors

Common errors: equating coupon with return; treating principal repayments as income; assuming collateral guarantees full recovery; using a call date as maturity; and interpreting a credit rating as a promise.

20Key takeaways and further reading

Start with the contract, draw the timeline, identify who can change it, then decide which risks affect each cash flow. A bond’s issuer, coupon, principal schedule, seniority, options and currency jointly determine its behaviour.

A complete comparison needs more than yield: examine cash-flow certainty, credit, liquidity, inflation, currency, reinvestment and embedded options. Use the laboratory to understand structures, then apply the actual terms to any real security.

• Investor.gov: Bonds — FAQs
• TreasuryDirect: Marketable securities
• RBI: Government securities market primer

Continue learning: Spot rates vs forward rates · Duration and convexity · All fixed income topics.

Educational study guide · The Mountain Path Academy · Illustrative calculations, not investment recommendations.

Teaching-note reference

Adapted from 01. Deep_Dive_into_Bonds_workbook.xlsx: Bond_Taxonomy_Overview; Cash_Flow_Structures; Yield_Pricing_Analytics; and Credit_Rating_Spread_Matrix. The numerical cases above are independently recalculated from the stated assumptions. Market-size figures, spread tables and recovery statistics without dated sources are not presented as current market facts.

For interest-rate conventions, see TreasuryDirect: Understanding Pricing and Interest Rates.