5 Main Types of Bonds Explained

| April 15, 2022
✓ Verified by Harshil Dhanky

Bonds represent a standardized contract between a borrower and a lender that agree on a coupon rate (also known as interest) and a maturity date/schedule of payments upon which the principal is paid back to the lenders.

There are other terms and conditions that stipulate actions a borrower can/cannot make, payment kind, claims on the borrower’s assets and more,  which are known as covenants and are part of the bond agreement.

Bonds are issued by several institutional borrowers such as Sovereign Governments, Sub-Sovereign and Supranational Issuers (States/Provinces/Agencies) as well as Corporate Borrowers.

Depending on the intended use of the proceeds from the bond issue, borrowers are able to create different payment structures and timelines for returning capital to investors. 

For example, Municipal bonds come in two kinds: Revenue Bonds and General Obligation Bonds, wherein the former can only be used to fund specific projects outlined in the bond indenture (contract associated with the bond) while the latter can be used for various purposes and there are no restrictions placed on the use of the proceeds.

Comparison: Different Types of Bonds

Sovereign Debt (Government Bonds) Sub-Sovereign Supranational Agency Debt
(SSA Debt)
Treasury Inflation-Protected Security (TIPS) / Real Return Bonds (RRBs) Corporate Bonds (Investment Grade and High Yield Bonds) Asset-Backed Securities 
Issuer Countries are issuers of Sovereign Debt States, Provinces, Municipalities, and Government Agencies are issuers of SSA debt Treasury Inflation-Protected Securities or Real Return Bonds are issued by Sovereign Issuers  Issued by private companies seeking to raise money using debt capital markets Issued by Corporate Issuers, but these securities are usually issued from a Special Purpose Vehicle, which is distinct from the Corporate Issuer
Risk of Default (Non-payment of interest/principal) Low for G10 countries Low risk of default with implicit sovereign backing in most cases Low for G10 countries Varies depending on Issuer’s credit rating, history of repayment, industry & more Varies on each issue and the group of underlying assets constituting the collateral
Yield (Investor expectations of return) Lowest, basis for pricing other types of bonds (US 10yr: 2%) Slightly higher than sovereign debt

(Ontario Govt 10yr: 2.16%) 

Investors compensated for change in inflation by adjusting principal  Higher than Sovereign, SSA bonds and premium added depending on issuer plus tenor of desired funding

(Scotiabank 5y Bond: 2.96%)

Varies based on each structure and the underlying basket of bonds contained 
Term 0 – 30+ years 0 – 30 years 5,10,30-year tenors only 0 – 30 years 0 – 30 years
Coupon Frequency Semi-annual Semi-annual Semi-annual Coupon frequency, payment method and rate varies depending on the issuer Varies by the issuer 

1. Sovereign Debt: Government Bonds

In the world of fixed income, the government debt of developed nations such as US, Canada, UK, France, Germany and other G10 nations are considered risk-free assets.

They serve as a baseline for investor expectations for other fixed income products wherein increment percentage points (called the “spread”) are added to the risk-free rate to compensate for taking additional credit risk (risk of default), liquidity risk and other idiosyncratic features related to those securities.

Government bonds are issued on the basis of the taxing authority of the sovereign nation and the ability to pay back its creditors by raising funds in domestic currency to pay off debt.

Coupon payments are made semi-annually and the principal is returned upon maturity.

Based on the maturity period of a particular fixed-income security, it can be called a bill (maturity less than a year), a note (usually matures between 1 to 10 years) or a bond that matures between 10 and 30 years.

Certain nations have issued securities maturing after 30 years, calling them ultra-bonds. 

The Central Bank sets the interest rate for overnight lending depending on prevailing economic conditions such as employment data, inflation rates and GDP outlook, and this influences investors’ expectations for the yields on different maturities such as 2, 5, 10, and 30 year bonds.

Considerations

Risk Parity Characteristics

Government bonds are fundamental blocks of creating a defensive portfolio and leading
investment firms such as Bridgewater Associates famously have used bonds as the defensive lever for their risk parity portfolio construction purposes.

Bonds go up in value in a flight to safety event while equities lose value in a risk-off move.

Sovereign debt is a great tool to build this intrinsic resilience into your portfolios.

Liquidity

Sovereign debt of developed nations is extremely liquid and can be traded/owned with relative ease. 

Safety

Government bonds are considered to be risk-free and have a minimal chance of default which reflects in the lower yields they offer in comparison to other bonds, which are considered riskier.

Inflation

Sovereign nations that borrow in their domestic currency have the luxury to print more fiat currency in order to pay borrowed funds, but as money supply increases it adds pressure to the costs of goods and services, which can be considered as inflationary in nature.

Large Notionals

As fixed income markets are dominated by institutional money, retail investors might find barriers to entry as most bonds have a large face value ($1M or more).

ETFs are a good way to get exposure to these securities for smaller nominal amounts.

2. Supranational, Sub-Sovereign, Agency Debt

These bonds refer to bonds that are issued by global organizations such as the World Bank and the IMF, provinces/states and governmental agencies

They are a notch below sovereign debt and are considered to have minimal default risk as they’re assumed to have an explicit guarantee by the nation as in the case of Ontario government debt or an implicit guarantee as in the case of Canadian Mortgage Housing Corporation (CMHC) issued debt

A small spread to the underlying government bond yield for the same maturity is added in order to compensate investors for taking on SSA credit risk, which is minimal, thus reflecting a very small increase in yields of these securities

Considerations

Portfolio Diversity and Objectives

As investors are now looking to allocate capital and use said capital to bring a positive change in the world, SSA bonds provide a great opportunity to invest in sustainability linked notes issued by World Bank and other such government agencies.

Further, a small bump in price is attributed to investing in these bonds and is referred to as the “greenium” which makes it attractive for these issuers.

Safety

As these bonds often come with sovereign backing, it becomes a great vehicle to pick up yield while not compromising on the quality of the credit.

Availability

Oftentimes, these securities are subscribed to by asset managers and they hold on to these bonds from the primary issue, so it can be hard to buy these bonds on the secondary markets.

Size

Smaller provinces might have limited funding needs and might not issue bonds as frequently as larger provinces such as Ontario and Quebec, leading to investors not having a lot of opportunities to round out their portfolio exposure to different regional economies.

3. Real Return Bonds (RRBs)

RRBs are Canadian government bonds that provide protection against inflation.

These bonds make coupon payments by modifying the interest rate, as well as the principal amount using the current Consumer Price Index (CPI) to ensure these bonds maintain their purchasing power. 

Considerations

Inflation Protection

As an aftermath of the pandemic, we are witnessing elevated levels of inflation, as fiscal dominance along with easy monetary policy has pushed up the prices of goods and services.

The RRB is an elegant product designed for such environments and investors can protect their purchasing power by investing in these bonds.

Liquidity

RRBs are auctioned as per a fixed schedule given by the Treasury and are not brought to the market as frequently as other Government of Canada bonds.

Investors can avoid this lack of inventory by choosing to invest in exchange-traded RRB ETFs.

Lady researching types of bond on tablet

4. Corporate Credit

Bonds issued by companies are referred to as corporate credit.

Based on their creditworthiness, each company is assigned a letter grade, which is similar to a credit score given to individuals.

Companies that have a lesser chance of default are called investment grade and are often well-established companies. 

Issuers with ratings below BBB are considered non-investment grade or high-yield issuers.

Canadian credit markets usually see issuers in the 7 to 10 year space and capital markets activity is limited in the long end of the curve.

Yields are calculated as a spread that is added to the underlying Government of Canada bond for the same maturity.

This spread represents the premium that investors demand to get compensated for taking exposure to this particular credit vs.

lending to the Canadian government for the same term. 

Considerations 

Variety of Issuers

Depending on the investor’s risk appetite, they can create a basket of credit ratings they want exposure to and can effectively manage their risk by selling the underlying Government of Canada bond to only have exposure to the credit risk and not take views on the path of interest rates.

Limited Number of Issuers

While debt capital markets are deep and function well in Canada, certain issuers issue sporadically and their new issues get oversubscribed by multiples of the offered size, thereby pricing these securities at a premium.

Investors can invest south of the border as the US boasts some of the most liquid corporate credit markets in the world and investors can get better value if they can navigate through the incremental currency risk exposure. 

5. Asset-Backed Securities

Investors like buying loans, credit, debt obligations from financial institutions, banking companies and commercial credit originators.

However, they don’t want to deal with borrowers individually to collect interest and service the debt.

Structures such as ABS (Asset-Backed Securities) provide a separate legal entity that holds all these credit obligations and issues securities against such financial assets.

These often get a bad rap after the financial crisis, but the underlying mechanism behind these structures is sound and any adverse results reflect on the collateral infused into these offerings that pose financial risks.

Considerations 

Tranching

By creating a pool of assets, issuers are able to manufacture fixed income products with certain risk profiles and characteristics that appeal to the investing community and fill a hole in their fixed-income portfolio holdings. 

Complexity

As alluded to before, there can be difficulty in ensuring the quality of collateral that is contained within these structures and the amount of due diligence completed before assigning credit ratings to these products.

There has been a significant revamp to how these products are created with increased regulatory filings and oversight to minimize investor losses.

Frequently Asked Questions

  • What are the 5 types of bonds?
  • Is bond debt or equity?

Sid Mohapatra is an energy trader based out of Toronto working in power and natural gas trading. Prior to working in commodities, Sid worked at a top Canadian bank’s fixed income and derivatives business. He possesses strong fundamentals in asset allocation, global macro thematic investing and physical commodities.

As a graduate of McMaster University, Sid specialized in Finance and has taught numerous sessions on Investing, Financial Securities and Trading courses. He led and managed the Horizon’s Trading Center at McMaster University.

Sid’s unique experience brings a breadth of institutional knowledge to the retail investing universe. He covers equity derivatives, structured credit instruments and tax harvesting techniques to help Canadians make better financial decisions in the ever-changing landscape of financial markets and investing.