An option free (straight line) bond is a simple form of bond. For example, a bond issued by the Treasury for a par value of, say $1000, with a maturity period of five with an annual interest rate of six per cent on maturity value. In such a case, the issuer, in this case – the Treasury pays an annual interest of $60 for five years, till the bond attains a par value of $1,000 and the Treasury redeems the bond to the buyer at a value of $1000 after five years from date of issue.
The interest on such bonds usually becomes due on a semi-annual basis, and in this case, may have to be paid at $30 each as interest amount after every six months on two pre-determined dates with a gap of six months each in each year till maturity. Thus, for a bond with a par value of $1000, an interest of $30 has to be repaid to the buyer nine times, before redeeming the $1000 in the final installment, apart from another $30 due as the last installment of semi-annual interest. The annual interest rate on basic bond or corporate bond is also popularly called as the coupon rate, which in this case is 6%. The payment of interest remains fixed and does not change over the life of the bond till its date of maturity. Hence, the issuer, in this case – the Treasury, remains aware of the upcoming liability to pay interest well in advance.
While the coupon rate for any bond is always referred as the annual rate of interest liable to be paid on bond and is taken as reference rate, the semi-annual coupon liability is always half of the annual interest due on such a bond. The par value at which the bond would mature after a period for which it is issued is the “face value” of bond. While usually, the basic bonds are issued in USD in the US, they could also be issued in other currency denominations.
While in developed markets, bonds have a strong market and are a popular method of raising funds, they are not so popular in the emerging markets due to lack of secondary markets for bonds. However, the bonds are fast emerging as a popular method of raising funds and markets in emerging markets are maturing now to give place to bonds trading in secondary markets.
Coupon rate structures
- Zero coupon bonds: These are bonds which do not carry any liability to pay any interest till the date of maturity, but are initially sold at a much discounted value to the face value on maturity. Say, in case of a bond with a face value of $1000 issued for a five years period, the same could also be sold initially at $650, and may carry the status of a zero coupon rate till maturity. The value at which it may be initially issued is usually close to discounted present value of the face value.
- Step up notes: This are bonds in whose case the rate of interest gradually moves up till the date of maturity for a specified period and for the later years, is usually paid at a higher rate than the initial years.
- Deferred coupon bonds: In such cases, the coupon payments accrue, but have to be paid only in the later period till maturity at a compound rate, after an initial deferral period. Such an interest is usually paid back to the buyer after initial deferral period in lump sum on the bonds. For a later half of the period, such bonds carry a normal coupon rate which is paid back semi-annually.