1.4.4. By Method of Determining Interest
Fixed Rate Bonds. Most municipal bonds are issued at a single, fixed interest rate. The interest rate is stated on the bond indenture as an annual rate and paid each year until the bond matures.
Floating Rate Bonds. Also called floaters, these are bonds whose interest rates are adjusted by a predetermined interest rate index. Interest rates are reset periodically at some fixed spread above the selected index. The spread might be 2% above the index, which remains fixed throughout the term of the bond. Interest rates may be reset daily, weekly, monthly, or annually. Commonly used indexes include SOFR and LIBOR, which are both discussed in Chapter 4, and the U.S. federal funds rate, which is discussed in Chapter 7. Floating rate bonds are the simplest types of variable rate security. Variable rate securities are long-term bonds having interest rates that are reset on a short-term basis. Variable rate securities may be useful in diversifying a municipality’s debt portfolio, and they have the advantage of reducing the cost of debt by paying short-term interest rates. However, the municipality is exposed to higher interest rate risk (discussed in Chapter 4). In contrast, from an investor’s perspective, variable rate securities are largely immune to interest rate risk.
Stepped Coupon Bonds. These bonds start with a lower-than-market interest rate, which gradually increases over the life of the bond. The rate increases occur at specific dates and at predetermined levels, as stated in the bond indenture. Issuers usually have the right to call the bond at par on any date that the interest rate is scheduled to change. Stepped coupon bonds are also known as step-up bonds.
Convertible Coupon Bonds. These bonds are sold as zero coupon bonds and then converted at some specified date (usually 8 to 15 years after issuance) to coupon bonds. These bonds are aimed at investors who want both growth and income at different tim