Plain Vanilla Bonds

What are the plain vanilla bonds?

Plain Vanilla bonds are debt securities issued by sovereign states, government agencies, supranational entities, listed and non-listed companies that give the holder the right to be repaid, at maturity, with the nominal value of the bond. Additionally, periodic coupons may or may not be paid during the life of the product. They are very simple tools and their name indicates precisely the linearity of their operation. The term 'Plain Vanilla ' refers to the basic version of the ice cream in the Anglo-Saxon countries.

Investment products that offer a remuneration to be payed periodically or at the final maturity of the instrument, guaranteeing the repayment of the nominal value

Listing and trading

Plain Vanilla bonds are financial instruments that can be bought and sold both on the MOT market (an electronic bond and government securities market) as well as on the multilateral trading facility EuroTLX of the Italian Exchange, in the event they are respectively listed and/or admitted to trading on these markets.Methods and trading hours of MOT and EuroTLX are specified in the relevant Rule books, available on the website of the Italian Exchange. For example, on both markets,trading in the continuous phase may take place on the open market days between 9am and 5:30pm.

Standard elements

Plain Vanilla bonds are characterized by standard elements which are:

NOMINAL VALUE: The value which will be re-paid on maturity of the bond;
COUPON: Periodic interest the issuer pays to the bond holder;
MATURITY: The date the bond holder is repaid the nominal value of the bond;
ISSUER: The company or State that issued the debit instrument.

Yield

As with most financial instruments, including Plain Vanilla bonds, there are several components that affect the final performance of the bond. The book value, the price that is paid during the purchase of the bond, is a determining factor. It is important to take into consideration the amount of coupon payments and whether the interest rate is fixed or variable. The bond price and interest rate are closely related to another factor in the determination of the level of performance of Plain Vanilla bond: the credit rating of the issuer. The higher the rating (a unit to measure and classify the financial strength of the issuer) the lower the bond yield (in respect of a bond instrument of similar duration and type).

The issue price

As regards the price component, a particular bond may be issued at three possible levels:

At par: Where the issue price coincides with the nominal value repaid at maturity of the bond (a 100 euro bond at maturity achieves 100 euro). In this case the price of the bond does not affect either positively or negatively on the overall yield of the bond at maturity;
Below par: The issue price is less than the nominal value at repayment of the bond. (A bond bought at 98 Euros and at maturity it is worth 100 euro). For bonds that provide the payment of coupons, this price difference is an element that increases the overall return that the investor will receive on maturity of the investment. For bonds that do not provide the periodic payment of coupons, so-called zero coupon bonds, the price difference is the overall return that the investor will receive on maturity;
Above par: The issue price is higher than the nominal value paid at maturity to the investor (a bond bought for 102 euro and at maturity will yield 100 euro to the investor). This higher price negatively affects the overall performance of the bond.

How they work

In the absence of extraordinary events that would lead to the insolvency of the issuer or in the absence of a guarantee of capital repayment, the investor on maturity receives the bond's nominal face value. During the life of the bond, the investor also receives a return on investment thanks to periodic coupons paid by the bond.

Example of how a fixed rate plain vanilla bond works.

Assuming a 3-year, fixed rate bond with a rate of 3%, with annual coupons and issue price equal to 100. The cash flow for the investor will be equal to:

Invested capital: 100 Capital cashed on maturity: 109

The main types of plain vanilla bonds

There are different types of Plain Vanilla bonds that allow the investor to undertake transactions which are more in line with his expectations of risk/return.

Fixed rate bonds

The fixed rate bond is the simplest bond available on the market. The investor is able to define from the time of purchase of the bond, the level of coupon payment received from holding the bond due to the fixing of a predetermined interest rate for the duration of the loan. The fixed rate bonds, however, have an element for potential negativity: the responsiveness of their prices to changes in the cost of money. In particular, an increase in interest rates leads to a loss in the market value of the bond, causing, in the event of sale, the capital loss to the bondholder.

Variable rate bonds

The variable-rate bonds are bonds with a predetermined coupon structure (coupons paid quarterly, six monthly, annually, etc…). However the recognised rate value of the periodic coupon changes over time and does not remain constant throughout the life of the bond as in the case of fixed rate bond. Typically, the bond coupon is determined by adding an excess return to a market rate such as Libor or Euribor. The excess return is given by the spread, i.e. the interest rate added to the market rate that the issuer pays the bondholder.

Step down and step up bonds

Step Up and Step Down bonds are a particular category of Plain Vanilla bonds. They are a mix between fixed-rate and floating rate bonds. Specifically, Step Down bonds are bonds with coupons decreasing over time, the Step Up bonds are bonds where the coupon rate rises during the life of the bond.

Zero-coupon bonds

Unlike fixed rate or variable rate bonds, zero-coupon bonds, also known by the acronym ZCB, do not pay interest in the form of coupons. The remuneration for the investor is only the difference between the redemption price and the purchase price of the security. This is why it is said that the performance is "implicit" because it is embedded in the difference between the two prices.

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