Some Types of Bonds
Callable Bonds
Many bonds have call features (or call options), which give the issuer the right to retire the bond prior to maturity. In such cases, the issuer is enabled, during specific time periods, to call, or repurchase, a bond away from its owner at a preset price that represents a small premium. The action is entirely at the election of the issuer, with no recourse to the holder. Most federal government bonds are not callable; corporate and municipal bonds usually are.
Issuers like the call feature because it gives them opportunities to refinance portions of their debt ifinterest rates decline. For example, a 20-year corporate bond might be issued at a rate of 11% with a provision that it can be called away from holders after five years at a price of $104 per $100 of principal value. If, five years later, the interest rate for similar bonds has dropped to 8.5%, the issuer would probably find it favorable to call the old bond and replace that debt with a new, and much cheaper, 8.5% bond.
Because of call features, bond investors can be hurt by both rises and declines in interest rates. Regardless of call features, when rates increase, the value of a bond will typically fall, as a means of adjusting its effective yield to that of alternative investments. In addition, a callable bond presents a further problem if interest rates decline enough perhaps two or three percentage points. In such cases, a callable bond will probably be repurchased from its owner. If that occurs, the investor will be unlikely to find another security of similar quality that will provide as high an income stream.
In addition to looking at characteristics such as credit worthiness and liquidity, therefore, prospective investors should always check on whether a bond is callable and under what terms. Because of this feature, the cash flow stream on callable bonds is somewhat unpredictable.
Convertibles Bonds
One way of counteracting the risk of inflation is to buy bonds or debentures
that are convertible into stocks. These securities typically provide many
of the safeguards inherent in non convertible debt securities yet permit
the holder to exchange his or her bond for a specified number of common
shares. The advantage of this type of bond is that if the stock price rises,
the bond is likely to rise in value also. This kind of upside potential
is part of convertible bonds' appeal. Because of this feature, however,
a premium must be paid for such bonds: They offer a lower interest rate
than regular issues of comparable quality and maturity.
Zero Coupon Bonds
Zero coupon bonds pay no interest until maturity; rather, they are
sold at a deep discount from face value and gradually achieve their face
value overtime. For example, a bond with a $1,000 face value intended to
yield 8% over 15 years would be sold initially for about $315. With a zero
coupon bond, you can lock in a relatively assured yield to maturity without
having to worry about reinvesting cash interest payments at varying rates
in the future. Nonetheless, although the bond owner does not actually receive
the cash until the obligation matures, income tax is owed on the implicit
interest that accrues each year. Thus, for individual investors, zeros
are primarily suitable for IRAs, Keogh plans, and other kinds of tax-sheltered
accounts. The most popular zeros are those backed by Treasury obligations.