Interest may be paid either at a stated fixed rate, or at a variable interest rate that is determined from time to time based on a stated process or formula.
Fixed Rate Bonds
The traditional form of bond pays a fixed rate of interest until maturity. This will be stated as the bond's interest rate or "coupon" rate. Fixed rate bonds typically pay interest semi-annually on specific interest payment dates. For example, if you own $10,000 of a bond with a coupon rate of 5 percent, you typically would be paid $500 of interest annually, payable in semi-annual installments of $250.
Variable Rate Securities
Another common form of bond pays interest based on a variable rate. Several different types of municipal securities pay variable interest rates. The most common types are variable rate demand obligations (VRDOs) and auction rate securities (ARS).
VRDOs \u2013 The interest rate for VRDOs typically is reset at short intervals (e.g., daily or weekly). VRDO holders have the right to tender or put back their securities to the issuer\u2019s designee in return for face value. VRDOs are long-term securities (e.g., maturity date of 30 years) with short-term interest rate periods. Interest rates are reset periodically through programs operated by dealers, called remarketing agents, on behalf of the issuers of the securities. The interest rate is set to allow the securities to be sold at par, although trades in VRDOs outside of the \u201cput\u201d feature described below are not guaranteed to occur at par. VRDOs typically have a high minimum denomination requiring a minimum investment of $100,000. See current interest rate information for VRDOs on EMMA.
A distinguishing characteristic of VRDOs is the existence of a \u201cput\u201d or \u201ctender\u201d feature that provides the investors with the right to require that the issuer or its agent repurchase the bonds from the investor at the full face value of the bond. Such optional puts generally can be exercised in conjunction with the reset of the interest rate to be paid on the securities for the next rate period. Typically, the issuer's remarketing agent will resell all securities that have been put to new investors, but in some cases a buyer cannot be immediately found and the issuer will draw on the letter of credit or other form of liquidity facility to pay the full face value of the bond to the investor. In the case of a stand-by purchase agreement, the bank does not undertake the guarantee that principal and interest will be paid, but provides only that tendered securities will be purchased so long as the stand-by bond purchase agreement remains in effect.
Issuers can also sometimes require that investors mandatorily tender their bonds back to the issuer, usually at a price of par and usually in conjunction with a conversion in the interest rate mode of the securities or under circumstances that would provide the issuer the right to exercise a mandatory redemption of the bonds.
ARS \u2013 Auction rate securities use an auction process to reset interest rates for short-term periods but do not provide liquidity guarantees to holders seeking to sell securities at the periodic auctions. ARS are long term securities that have variable interest rates that reset on a short-term basis. The typical auction process is one referred to as a Dutch auction. At each auction, investors have the option to hold, sell, or buy additional securities at par. If there are a sufficient number of purchase bids to match the offered sales on the terms indicated in the bids and offers, the auction will succeed and the interest rate for the next rate period will be set at the lowest "clearing" rate necessary to achieve such matching. Otherwise, the auction will fail, current owners of the securities will retain their ownership, and the interest rate for the next rate period will be set at the "fail" rate, which typically is a relatively high rate. If no current owners of the securities wish to sell at an auction, they will retain ownership and the interest rate for the next rate period will be set at the "all-hold" rate, which typically is a relatively low rate. Auctions are conducted by agents of the issuer of the auction rate security, called auction agents, and orders are submitted to the auction agent by certain dealers, called program dealers, that have rights granted to them through an agreement with the issuer to submit orders. Trades in ARS outside of the auction procedure described above are not guaranteed to occur at par.
\u201cAll hold\u201d rates often are linked to a market index and generally are intended to be lower than a clearing rate. Maximum rates can be a specific fixed interest rate or linked to a market index. The market for auction rate securities experienced an extreme dislocation beginning in early 2008 and continues to be largely illiquid, although a limited number of ARS continue to receive purchase bids and appear to experience successful auctions. See current information for ARS on EMMA.
Other variable rate securities \u2013 Other less common forms of municipal securities that pay variable interest rates include, but are not limited to, securities whose rate is set by formula, usually based on an independent index rate such as LIBOR (London Interbank Offered Rate) or other market index. In addition, commercial paper, which typically matures within 270 days or less of maturity and can be refinanced or \u201crolled-over\u201d with additional newly issued commercial paper, has many, but not all, of the same characteristics of variable rate securities.
In some cases, municipal issuers will sell notes that mature relatively soon after issuance, sometimes less than one year after issuance. For these types of short-term notes, issuers sometimes will forego an interim payment of interest prior to maturity but instead will pay all interest at maturity of the note.
Zero Coupon Bonds or Capital Appreciation Bonds
Some bonds do not pay interest periodically but instead accumulate interest earnings until the bond matures, at which point the principal and all accumulated investment earnings are paid. Typically zero coupon bonds are issued at a discount to their maturity value. The bond will typically be sold having an initial principal amount and a separate maturity amount, with the difference between these two amounts effectively representing the interest earnings.
This bond feature allows the investor to redeem the bonds typically at par value on a specific date prior to the bonds maturity date. Conversely, a mandatory put allows the issuer to call the bonds at a specified date prior to maturity whereas the investor cannot retain the bond.
Original Issue Discount Bonds
An original issue discount bond, or OID bond, is a bond that was sold at the time of issue at a price that included an original issue discount. The original issue discount is the amount by which the par value of the bond exceeded its public offering price at the time of its original issuance. This discount is amortized over the life of the security and, on a municipal security, is generally treated as tax-exempt interest. When an investor sells the security before maturity, any profit realized on such sale is calculated (for tax purposes) on the adjusted book value, which is calculated for each year the security is outstanding by adding the accretion value to the original offering price.
Similarly, issuers will sometimes issue fixed rate bonds at a price above 100 percent, or at an "original issue premium." In such a case, an investor who purchased this bond at original issuance at the premium price who holds this bond until maturity will be paid the face amount of the bond, which will be less than the original purchase price. Although the investor will receive periodic interest payments over the life of the bond as with any other bond, the difference between the premium price and the face amount of the bond will effectively reduce the total overall returns received by the investor. As with discount bonds, federal tax law may provide different treatment for original issue premium bonds and bonds traded in the secondary market at a premium above par.