What are complex bonds?
While traditional bonds are fairly straightforward, complex bonds have additional features that introduce complexities in characteristics, risks and potential returns.
Types of complex bonds
Complex bonds come in a variety of types, including perpetual bonds, subordinated bonds, callable bonds, inflation-linked bonds, convertible bonds, floating rate bonds and structured bonds.
- Inflation-linked bonds: Bonds where the coupon is linked to the development of inflation in the relevant market.
- Perpetual bonds: Bonds with no predefined maturity date. Instead, most perpetual bonds have specific call-dates included, where the bond can be redeemed at par.
- Convertible bonds: This type of bond can be converted to common equity of the issuer, usually at the request of the bondholder for a predefined number of shares at a predefined time.
- Contingent convertible bonds (CoCos): Bonds issued by financial institutions that will be converted to common equity if the issuer fails to live up to certain financial ratios.
- Floating rate bonds: Bonds with a variable coupon rate. The coupon is typically linked to a publicly available interbank rate and will be subject to change every three, six or 12 months during the bond’s lifetime.
What are the risks when trading complex bonds?
When trading complex bonds, it’s important to be aware of the potential risks. These include:
- Market risk: Potential losses due to factors affecting the performance of the overall bond market. The main risk impacting the bond market is interest risk, i.e., when interest rates go up, bond prices go down. For fixed rate bonds, the longer the duration, the higher risk of price changes due to interest rates moving up or down. or down.
- Liquidity risk: Less liquid bonds will usually have a larger bid/offer spread, which impacts the return (Yield to Maturity ) you can expect. Liquidity declines when there is a reduction in the number of buyers and sellers.
- Call risk: If a bond can be called (redeemed) at par prior to maturity (also known as a callable bond), this will impact the expected return compared to holding the asset until maturity, e.g., if a corporate bond is called the issuer will buy the bond back at a pre-determined price..
- Credit risk: Probability of the other party in a transaction failing to fulfill contractual obligations. For most bonds, the main risk is that the issuer (borrower) fails to repay the notional amount at final maturity. Credit agencies provide ratings of most bonds issued, which helps investors to assess the credit risk for each bond.
Credit risk is also impacted by potential subordination of bonds by the issuer. This means that, by design, the subordinated bondholders will get paid after non-subordinated bondholders and creditors, and will as such be subject to more credit risk. On the other hand, credit risk can also be lowered for bonds where the issuer has pledged collateral as security for bondholders – this is, for example, the case for covered (mortgage) bonds.
5. Currency risk: As with other investments, you can be subject to currency risk if you buy bonds issued in a different currency than your main currency.
How much can you lose in complex bond trading?
When trading complex bonds, your maximum loss is limited to the invested amount and usually this will only happen if the issuer defaults and will not be able to repay the notional amount at final redemption.
Other costs and charges
When you trade complex bonds, you could face these additional costs or charges:
Commission or brokerage fees for executing trades. There’s no difference in commissions for complex and traditional bonds.
At Saxo, the commission is paid as a one-off fee measured as a percentage of the total amount traded. This means the commission will impact the return more for shorter maturities.
The spread is the difference between buy and sell prices. More complex bonds may be less liquid, and therefore have a wider spread and thus, a higher spread cost.