Types of bonds and debt instruments

A government bond, a bank note, a Treasury bill and a security backed by car loans are all loans. The borrower takes your money today and promises to pay it back. The paper that records the promise is a debt instrument. The market sorts these instruments into types, because the type tells you who owes the money and where the money comes from.

This guide explains the main types of debt instrument and how each one works. It lists what to check before you buy. It then shows the instrument types that BondSmartly uses, where they come from and how they differ from the interest types.

1. What is a debt instrument?

A debt instrument is a security that records a loan. The issuer borrows the money. You lend it. In return the issuer promises to pay interest and to repay the amount on a set date, or on several set dates. The promise is written in a prospectus or in the final terms of the note.

Each instrument has a face value, which is the amount repaid per unit. The coupon can be fixed or floating, or there is no coupon at all. Many instruments have a maturity date. A perpetual bond has none. Most of them trade on an exchange or between banks, so you can sell before the end.

2. Why does the market sort debt into types?

The type answers two questions before you open the prospectus. Who owes you the money? And what pays the coupon? With a plain corporate bond, one company owes you the money and pays you from its profits. With an asset-backed security, a special company owes you the money, and the payments of thousands of borrowers pay the coupon. The risks differ, and so do the documents you need to read.

Regulators use the type as well. Every instrument in the EU FIRDS register carries a CFI code, the six-letter classification of the ISO 10962 standard. For debt, the first letter is D. The second letter names the group. BondSmartly reads that letter, as section 5 shows.

3. The main types of debt instrument

Government and corporate bonds

A plain bond is the standard form. The issuer pays a coupon on set dates and repays the face value at maturity. A government issues bonds to fund its budget, and a company issues them to fund its business. Government bonds in large currencies trade every day in large amounts. Many corporate bonds trade less.

Check the denomination before you buy. Some corporate bonds sell in units of 100,000. Look at the date of the last trade. Read whether the issuer can call the bond early, and at which price. If the bond is subordinated, the article on senior and subordinated bonds explains what that means for you.

Medium-term notes

A medium-term note is a bond that a bank or a company issues under an issuance programme. In Europe the programme is often a Euro Medium Term Note programme, or EMTN. The issuer writes one base prospectus for the whole programme. Each note then gets a short document, the final terms, with its own coupon and its own maturity. The name says medium term, yet the maturities run from one year to 30 years or more.

The flexibility is the reason the programme exists. One programme can produce a plain fixed-rate note this week and a note with a floating coupon next week. So read the final terms of the exact note you want. Check the denomination, since many notes sell in units of 100,000. See whether the note is senior or subordinated, and whether the issuer can call it.

Municipal bonds

A municipal bond is issued by a region, a state, a province or a city. German Länder and Spanish regions issue them, and so do many cities. The region owes the debt on its own. Check the finances of the region and the support rules of its country. Also check how often the bond trades. Many municipal bonds sit with banks and insurers for years.

Money market instruments

Money market instruments are short debt with a maturity under one year. Governments sell Treasury bills, for example BOT in Italy or Bubills in Germany. The company version is called commercial paper. Most of these instruments pay no coupon. You buy below 100 and get 100 at maturity, as with a zero-coupon bond. The article on zero-coupon bonds shows how to work out the yield. Check the minimum amount. Commercial paper often sells in large units to professional investors.

Convertible bonds

A convertible bond can turn into shares of the issuer. It pays a coupon, usually a lower one than a plain bond of the same company, because the right to convert has a value of its own. The terms set a conversion price and a conversion period. If the share rises above the conversion price, the bond rises with it. If the share falls, you still hold a bond, and the issuer still owes you the face value at maturity.

Check the conversion price and the dates. Find out whether the issuer can force a conversion or call the bond when the share is high. Some convertibles are subordinated, which puts you behind other lenders if the company fails.

Bonds with warrants

A bond with warrants is a plain bond with a separate right to buy shares at a set price. The right is the warrant. The two parts can often be split and traded on their own. After the split, the bond trades as a plain bond, often with a low coupon. Check whether the warrants are still attached to the units you buy. The warrant has a strike price and an expiry date, and both are in the terms.

Asset-backed securities

An asset-backed security, or ABS, pays you from a pool of loans or receivables. Car loans, credit card balances, consumer loans and leases are common pools. A bank sells the loans to a special company, and that company issues the securities. The borrowers in the pool make their payments. The money flows through to you. The credit of the bank that set up the deal matters little, since the pool is what pays.

Most ABS deals have several classes. The senior class is paid first, while the junior classes take the first losses. The pool pays down as borrowers repay, so you get your money back in parts, and the end date can move. Before you buy, find the class you are looking at and read how the pool has performed so far. The prospectus says how fast the pool pays down and what happens when many borrowers repay early.

Mortgage-backed securities

A mortgage-backed security, or MBS, is an asset-backed security whose pool holds mortgages. With home loans in the pool it is a residential MBS. A commercial MBS holds loans on offices or shops. The payments of the homeowners pay your coupon and your principal. Homeowners repay early when rates fall, so the cash can come back sooner than planned. When rates rise, it comes back later. This prepayment risk is the main thing to study. Also look at the loan-to-value of the pool and the share of loans in arrears.

Covered bonds

A covered bond is issued by a bank and backed by a pool of assets, in most cases mortgages or public sector loans. The pool stays on the balance sheet of the bank. You have a claim on the bank and, if the bank fails, a claim on the pool. EU law sets rules for the pool and for its supervision. The instrument types in section 5 have no group of their own for covered bonds. Read the prospectus of a bank bond to see whether it is covered.

Depositary receipts on debt

A depositary receipt on debt is a certificate that stands for a bond held by a bank or a depositary. The receipt trades in one market, while the bond itself sits in another. You hold the receipt and get the payments of the bond through the depositary. These receipts are rare in Europe. Check which bond the receipt stands for and what the depositary charges.

Structured products

A structured product is a note whose payout depends on something else: an index, a share, a basket of shares, a currency or a credit event. The issuer is often a bank. Some structured notes protect your capital at maturity as long as the issuer survives. Others can repay less than you paid, or repay in shares. The coupon can be zero in some years and high in others.

Read the final terms with care, and find the formula for the coupon and the formula for the repayment. Then work out the worst case. The price before maturity often comes from the issuer alone, so check how the note trades.

4. The types compared

5. Instrument types on BondSmartly

A bond on BondSmartly gets its instrument type from its CFI code. The CFI code is the ISO 10962 classification of financial instruments. Every instrument in the EU FIRDS register carries one. The second letter of a debt CFI code names the group, and that letter sets the type you see on the site.

The screener has an Instrument filter and an Instrument column. The table lists the values, with the CFI letter in brackets.

Two CFI groups are missing from the table. Group S holds structured products with capital protection, and group E holds those without it. BondSmartly leaves both groups out.

The Screener link in the menu of the site opens the screener with only the Bond type selected. Choose more types in the Instrument filter to see the others. On a bond page, the instrument type is one of the key facts of the bond, under Instrument.

Instrument type and interest type are two different things

The instrument type says what kind of security the bond is. How the coupon works is a different question, and the interest type answers it. The screener has a second filter for the interest type, with these values:

• Fixed rate
• Zero coupon
• Step-up
• Fixed-to-floating
• Floating rate
• Inflation-linked
• Structured
• Payment in kind
• Variable (other)

A medium-term note can pay a fixed coupon or a floating coupon. The interest type Structured means that the payout depends on something else, such as a share or an index. Some notes with that interest type are still in a listed group, for example Medium-term note. So a filter on the instrument type alone does not remove every note with a structured payout. Add the interest type filter when that matters to you.

The CFI group is the class that the issuer or the register gave the instrument. It does not tell you everything. Read the prospectus or the final terms to see what a note pays and what you can lose.

Summary

• A debt instrument records a loan. The issuer promises interest and repayment, in a prospectus or in final terms.
• The type tells you who owes the money and what pays the coupon.
• Plain bonds, medium-term notes, municipal bonds and money market instruments are paid by the issuer. Asset-backed and mortgage-backed securities are paid by a pool of loans.
• Convertible bonds and bonds with warrants give you a way into the shares of the issuer.
• On BondSmartly the instrument type comes from the second letter of the CFI code. The structured product groups S and E are left out.
• The interest type is a separate filter. A medium-term note can pay a fixed or a floating coupon, and some notes have a structured payout.
• Read the final terms of the exact note before you buy. The CFI group alone does not say what a note pays.