All bonds have different bond payment terms so it’s important to understand the various types of bond payments, frequencies, interest rates and maturities options for a bond contract.
All bond payments have different terms that are defined in a legal contract normally referred to as the indenture. The borrower promises to pay interest (also known as a coupon) to the bondholder over a certain term, at the end of which the borrower returns the principal amount originally borrowed.
Understanding the basic concepts of payment type, frequency, interest rate and maturity will provide you with substantial working knowledge of bond payment terms.
Bond payments can be fixed or floating. A generic fixed-pay (fixed-coupon) bond will make the same payment at a pre-determined interest rate and frequency until maturity. A floating rate bond will make payments based on a benchmark interest rate that changes through time. Some common floating rate benchmark interest rates are CDOR (Canadian Dealer Offered Rate) and LIBOR (London Interbank Offered Rate).
Bond payments can be as frequent or infrequent as agreed to between lender and borrower. The most common payment frequency elected in the bond market is the semi-annual fixed-coupon structure, generally referred to as a “plain vanilla” bond. However, payment frequencies can range anywhere from daily to monthly to annual and longer.
The interest rate is determined prior to the issuance of the bond. The lender (investor) spends considerable time and effort assessing the credit quality of the borrower to determine the likelihood of repayment. A borrower with a stronger credit quality is more likely to issue a bond with a lower interest rate because the lender is confident that his or her money will be returned. The ultimate interest rate agreed to in the indenture would reflect the market interest rate environment. Investors pay close attention to other bonds to help them gauge a fair level at which they would be willing to lend.
The bond indenture will outline the specific date on which the final coupon and repayment of original principal is due. Bonds can have terms (time to maturity) ranging from months to more than 50 years. Certain bonds can also have call or put options which affects the length of time the bond remains outstanding and pays interest. Call option on an bond allows the issuer of a bond (AKA the borrower) to pay back the full amount of the bond after a specified black-out period. Put option on a bond allows the buyer of the bond (AKA the investor) to force full payment of the bond after a specified black-out period. Call options benefit issuers, while put options benefit investors.