Classification on the basis of Variability of Coupon

• Zero Coupon Bonds - Zero Coupon Bonds are issued at a discount to their face value and at the time of maturity, the principal/face value is repaid to the holders. No interest (coupon) is paid to the holders and hence, there are no cash inflows in zero coupon bonds. The difference between issue price (discounted price) and redeemable price (face value) itself acts as interest to holders. The issue price of Zero Coupon Bonds is inversely related to their maturity period, i.e. longer the maturity period lesser would be the issue price and vice-versa. These types of bonds are also known as Deep Discount Bonds.

• Treasury Strips - Treasury strips are more popular in the United States and not yet available in India. Also known as Separate Trading of Registered Interest and Principal Securities, government dealer firms in the United States buy coupon paying treasury bonds and use these cash flows to further create zero coupon bonds. Dealer firms then sell these zero coupon bonds, each one having a different maturity period, in the secondary market.

• Floating Rate Notes(FRNs) - In some bonds, fixed coupon rate to be provided to the holders is not specified. Instead, the coupon rate keeps fluctuating from time to time, with reference to a benchmark rate. Such types of bonds are referred to as Floating Rate Bonds.
  
  For better understanding let us consider an example of one such bond from IDBI in 1997. The maturity period of this floating rate bond from IDBI was 5 years. The coupon for this bond used to be reset half-yearly on a 50 basis point mark-up, with reference to the 10 year yield on Central Government securities (as the benchmark). This means that if the benchmark rate was set at “X” %, then coupon for IDBI’s floating rate bond was set at “(X + 0.50)” %.
  
  Coupon rate in some of these bonds also have floors and caps. For example, this feature was present in the same case of IDBI’s floating rate bond wherein there was a floor of 13.50% (which ensured that bond holders received a minimum of 13.50% irrespective of the benchmark rate). On the other hand, a cap (or a ceiling) feature signifies the maximum coupon that the bonds issuer will pay (irrespective of the benchmark rate). These bonds are also known as Range Notes.
  
  More frequently used in the housing loan markets where coupon rates are reset at longer time intervals (after one year or more), these are well known as Variable Rate Bonds and Adjustable Rate Bonds. Coupon rates of some bonds may even move in an opposite direction to benchmark rates. These bonds are known as Inverse Floaters and are common in developed markets.
• Stepped Coupon Bonds
   Stepped-coupon bonds are a variation of straight fixed rate bonds that have been issued by some borrowers. These are securities whose coupon rate increases during the life of the bond.
  
  For example, a 5-year ‘step-up’ bond might be issued with a coupon of 5% for the first year, 5.5% for the second year, 6% for the third year, and so on. After an initial non-callable period, step-up bonds are callable at each step-up date and are therefore attractive to issuers with a strongly held view that interest rates will fall – a replacement bond can then be issued at a lower rate.
  
  Bonds with stepped-coupon features were quite popular with some telecommunications issuers in early 2000. Due to the uncertain credit outlook for these issuers, these bonds offered investors an incentive in the form of a coupon step-up if the issuer’s credit rating fell. The stepped-coupon feature of these issues essentially represented a form of bond covenant.
  
  A bond whose coupon increases in response to the weakening of the issuer’s credit rating is sometimes referred to as a ‘structured credit’ bond. The downside for investors in these issues is that the coupon often also ‘steps-down’ in the event of a ratings upgrade.