Meaning of Bonds
Bonds are financial instruments used to raise debts from the open market. One of the most common types of bonds is plain vanilla bonds. These are the most basic bonds.
Going by the name, if 100 customers go to the ice cream store, most of them would order vanilla-flavored ice cream. Further, many of them would want extra flavor added to vanilla.
So, we call the bond with basic features and wanted by all as plain vanilla bonds. Plain vanilla is used in various financial products as plain vanilla options, plain vanilla swaps, plain vanilla credit cards, and so on. Under plain vanilla bonds, fixed coupon payments are determined at regular intervals and maturity is also pre-determined.
Liquidity in Plain Vanilla Bonds
Boring things are easier to transact as these are usually transacted at the exchange. Plain vanilla bonds are basically the benchmark bonds with large issues where the transaction can be done with a very tight spread. There are always buyers and sellers in plain vanilla bonds. They are tight and easy to trade.
These bonds also have a decent variety and maintain the market position. Exotic bonds have lower liquidity resulting in higher spreads and enable more risky offerings.
The investors can benefit heavily from plain vanilla bonds issued by highly rated companies as AA or AAA-rated ones. Liquidity is the key in any market and Plain vanilla bonds are king in the segment.
Example of Plain vanilla bonds
A 5-year bond that pays 5% annual coupon rate (payment semi-annually) with the face value of $100. Therefore, in this plain vanilla bond –
Coupon Rate = 5% of $ 100 = $ 5 per year
Time of coupon payments = semi-annually = $ 2.50 every 6 months ($ 5/2)
Date of Maturity = 3 years from the date of purchase
Face Value = $ 100.00
There are many features that can be made in this plain vanilla bond as per issuer’s or investors requirement.
Features of Plain vanilla bond
- Coupon rates and tenure and time of coupon payments are fixed\
- Maturity is pre-determined at the time of issue.
- These bonds have a par value.
- These are very simple bonds and comes with standard terms and conditions in the market.
Dynamic coupon rates
Bonds can have fixed coupon rates, zero rates or can be the nature of step-up bonds. Under plain vanilla bonds, this is not particularly the case. The plain vanilla bonds coupon rate remains constant throughout the life of the bond.
Feature of callable/puttable
In plain vanilla callable bonds, the issuer has a right to call the bond before the date of maturity. While in the case of puttable plain vanilla bonds, the investor has the right to redeem the bond before maturity.
The date of maturity, therefore, becomes flexible in various bonds. This is not the case of plain vanilla bonds where the date of maturity is fixed and cannot be changed.
Bonds often comes with convertible option meaning they can be converted into equity shares or preference shares at a pre-determined date. A plain vanilla bond is not convertible. It must be redeemed at the date of maturity and it cannot be converted into any other type of security.
4 Advantages of Plain vanilla bond
1) Simple valuation computation
To value a financial instrument, the cash flow shall be estimated over the life of that instrument. The cash flows in plain vanilla bonds are pretty straightforward as they are just the regular payment till the date of maturity. Such easy cash flow computation makes the valuation of plain vanilla bonds very easy.
2) low volatility risk
Returns under plain vanilla bonds are safer than other exotic bonds. The simple reason being its essential features and liquidity. Such liquidity allows it to trade at tighter spreads which reduces the volatility risk of the company. Hence, the risk of volatility is completely avoided in plain vanilla bonds.
3) Higher liquidity
Imagine an ice cream shop, most buyers buy vanilla-flavored ice creams, and hence, the most sales realization would be from the selling of vanilla-flavored ice creams.
The same phenomena apply to plain vanilla bonds as well. A large number of investors transact at higher frequency in plain vanilla bonds and hence, they have higher liquidity.
The primary disadvantage of a plain vanilla bond is that, unlike other financial products, these bonds cannot be adjusted so as to reflect the current market conditions and rates established in the market.
So, when the rates become favorable to the investor, they would not be able to benefit from the rate adjustment.