Bond innovation is a continuous process. Companies innovated and used different types of bond in the passage of time. They first used zero coupon bond in a major way in 1981. In recent years, many large companies like IBM and J.C Penney have used zero coupon bonds to raise large amount of capital.
Similarly, in early 1980s, company used floating rate debt. By using floating rate debt, firms can issue debt with a long maturity without committing themselves to paying a historically high rate of interest for the entire life of the loan. Another innovation is the junk bond. Prior to the 1980s, it was almost impossible for risky companies to raise capital in the public bond markets. But in 1980s, they issued junk bond (high risk, high yield bond) to finance mergers and leveraged buyouts. However, its use has diminished in recent years.Following are the some types of bond innovations:
1. Zero Coupon Bonds
Zero coupon bonds, as the name implies, have no coupon rate. Hence these bonds are issued at a substantial discount from the par value. Though zero coupon bonds do not pay any interest during holding period they provide return to investors in the form of capital appreciation. Companies prefers to issue zero coupon bond when their cash flow is not regular.Government bonds and municipal bonds may also be issued without coupon interest.
2. Floating Rate Bonds
Instead of issuing a fixed interest rate debt instruments, company can issue floating rate notes/bonds. Interest rate on such bonds is tied to the treasury bond (government bond) or some market rates. In a volatile interest-rate environment, companies are reluctant to commit to long-term debt. They use floating rate bonds n this situation to reduce risk.
Although interest rates are not quoted in these bonds, a minimum or floor rate is often specified. This provision ensures bondholders a minimum rate of return.
3. Junk Bonds
Some bonds are issued by weak companies hence bear substantial risk. Such types of bonds provide relatively higher return. These bonds which have higher return and higher risk are called junk bonds. Generally, junk bonds are issued through private placement. In addition, junk bonds are used in acquisition and leveraged buy-outs.