Types of Income
Investors considering fixed income investments such as bonds and preferreds can choose those securities most in tune with their objectives and cash flow needs.
Fixed Coupon Bonds
The coupon rate is set at the time of issuance and will remain constant over the life of the bond, even as the securities’ prices may fluctuate to adjust to changing interest rates. The interest payments are predictable and are typically paid semi-annually, quarterly, or monthly. Investors who desire to supplement their income may want to consider fixed coupon bonds.
Step-Up Bonds
These bonds' coupons increase over time, generally in equal increments, according to a predetermined schedule. These securities are typically issued with a call feature and are often callable on coupon payment dates. They may make sense for slightly bearish investors who are reluctant to buy long-term. Investors may be accepting lower yields initially than comparable fixed-rate securities in return for the potential of receiving higher yields over the life of the investment. However, there is a greater likelihood that the issuer will call these bonds when prevailing interest rates are lower than the current coupon. This may affect the yield on the security. Also, these bonds offer limited premium potential due to the possibility of a call.
Floating Rate Bonds
The coupon payments on these bonds are tied to a reference benchmark, such as short-term Treasury bills, LIBOR, or CPI indices, and will vary as the corresponding index is reset. The interest rate is quoted as a number of basis points (bp) over an index, which is also called the spread (100 bp = 1.00%). For example, a bond quoted at LIBOR + 250 bp would be the LIBOR rate plus 2.50%. The spread is determined at the time of issuance and will remain fixed until the bond matures. As the index adjusts, so too will the interest payment, which may occur monthly, quarterly, semi-annually or annually depending on the individual issue.
Fixed to Float
Some issues have a fixed to float feature which allows for the income to float based on a certain benchmark after paying a fixed rate for a period of time. Changes in income payments may significantly affect yield and consequently the price may decline significantly.
Zero Coupon Bonds
These bonds are issued at deep discounts and do not make any interest payments during the life of the bond. Instead, interest is compounded until the full face value is achieved at maturity. For this reason, these bonds tend to be more volatile. If sold prior to maturity, they may be subject to capital gains or losses. These securities may be suitable for investors who are trying to meet future financial obligations, such as college tuition, because at maturity the issuer will repay the full face value*. Because accrued interest income from zero coupon bonds is subject to taxes annually as ordinary income – even though no income is received – many investors hold zero coupon bonds in tax-deferred accounts.