There exist different types of bonds. We are going to help you better understand complex bonds which you can purchase and the consequences regarding risk and return. Complex bonds provide a different risk/return profile than traditional bonds.

Complex bonds, as their name suggests, are somewhat more difficult to understand than traditional bonds. While they are intended for experienced investors, many portfolios include at least some complex bonds through investments in funds.

What are the different types of complex bonds?

Convertible bonds are composed of a plain vanilla bond with an embedded equity call option. In other words, the holder of the convertible bond has the option to convert a specific underlying equity into a set number of securities (in accordance with predetermined conditions).

An example
You have subscribed to a convertible corporate bond with a 1,000 euro face value and a 5 year term. When the convertible bond matures, you will be able to exchange your 1,000 euro convertible bond for 10 shares of the same company.

If this company's stock is listed at 90 euros at maturity, this exchange is not interesting: 10 shares at 90 euros is less than the value of your 1000 euro bond. Trading your bond for shares becomes attractive when the share price exceeds 100 euros: in this case, the value of the 10 shares is greater than the par value of your bond.

Please note: companies are free to determine the conditions of the exchange themselves (information is available in the prospectus or fact sheet).

The convertible bond is interesting because you can potentially swap your bond for stocks, and in so doing, profit from the rise in stock prices. This is why these bonds earn a lower interest than regular bonds.

Convertible bonds tend to pay lower coupons than plain vanilla bonds with equivalent maturities and credit risk. Issuers of convertible bonds tend to have poor liquidity and are often of lower quality than those of plain vanilla bonds. As a result, investors may prefer to enter this market through an investment fund.

Inflation-linked bonds are another type of complex bond. Their principal and coupons are linked to inflation and, as a result, the coupons tend to be low. Since the price of this type of bond includes an implicit rate of inflation, their appeal depends on the relationship between the implicit rate (which reflects the market’s inflation forecast) and actual future rates of inflation. In other words, if inflation were to increase more than expected, the coupons and the principal of the inflation-linked bond would also rise.

Perpetual bonds, as their name suggests, have no fixed term and no maturity date. Because they do not mature, they tend to be more sensitive to interest rate changes than plain-vanilla bonds. Perpetual bonds are also subordinated (i.e. they are redeemed after all other creditors). However, they tend to offer an annual coupon that is significantly higher than the rates offered by plain vanilla bonds.  Finally, investors should note that some perpetual bonds carry the possibility of forced repayment after a specified date.

Other complex bonds are in most cases backed by assets such as mortgages, student loans or car loans. These assets are first ‘securitised’ (i.e. they are transformed into negotiable securities). In this way, a bond backed by securitised assets will enable payment flows to be generated, in the form of interest and redemption of principal, which are directly linked to the assets. Examples of this type of bond include Mortgage-Backed Securities and Asset-Backed Securities. These types of complex bonds are especially difficult to understand and generally carry a high level of liquidity risk.

What types of risk are associated with complex bonds?

• Credit risk – Sometimes issuers are not able to honor interest payments or repay the principal at maturity. Credit risk is greater when bonds are subordinated, because this means that they will only be repaid after all other creditors have received repayment.
  In addition, credit risk increases when an issuer’s financial situation deteriorates. This will also result in higher yields for bonds from the same issuer, and a decline in the price of the bonds (meaning that if they are sold before maturity the holder will have a permanent capital loss).

• Liquidity risk – Investors in convertible bonds, perpetual bonds and bonds backed by securitised assets are particularly exposed to liquidity risk, meaning that they may not be able to convert their investments into cash without giving up capital and income due to an insufficient number of buyers.
  ​If an issuer’s rating is downgraded it may become difficult to sell the bond on the secondary market. Smaller issue sizes tend to carry lower credit ratings, and if trading volumes are not sufficient the bond could be sold at a significant discount.

• Interest rate risk – An increase in interest rates means that recently issued bonds will offer higher returns than existing bonds, which, if sold before maturity, will then make a capital loss.

• Currency risk – When complex bonds are issued in a foreign currency, exchange rate fluctuations will impact the amount received in your reference currency in the event of a sale or at final maturity.