Plain vanilla is a term in finance used for securities without special features. The Plain vanilla concept may apply to Options, Futures, Swaps, and Bonds. It depicts the simplest of the forms for financial instruments and securities. It means there are no special features attached to a financial instrument such as a Call or Put feature.
Deeper Definition
A Plain Vanilla Bond is the simplest form of bond. It comes with predefined features and does not offer any special features.
The term plain vanilla refers to the simplicity of the financial instrument. A plain vanilla bond comes with predefined features such as maturity date, coupon rate, issue price, and face value. Over the life of a bond, these values do not change as compared to other types of bonds.
How Does a Plain Vanilla Bond Work?
Bonds are issued by the government, semi-government, and corporate financial entities to raise capital. A bond is defined in features by its issuer. The sovereignty of a bond issuer is of utmost importance for investors. A plain vanilla bond is issued with no special features. The US treasury bills are a good example of plain vanilla bonds.
These bonds are issued with predefined features such as issue price, face value, coupon rate, maturity date, and so on. Investors can calculate the market price of these bonds and all cash flows in the present value term. It means investors can be assured of the total income arising through coupon payments in advance. Also, despite changing interest rates, these bonds cannot be called by the issuers. It offers further stability for investors.
Let’s see how these features are set in a plain vanilla bond.
Issue Price
It is the price of the bond at which it will be sold in the market. It can be offered at a discount to attract investors.
Face Value
It is the nominal value of the bond at which it will be redeemed at maturity. It is commonly denoted as $ 100 or $ 1,000 terms as the face value of the bond.
Coupon Rate and Frequency
The Coupon rate of these bonds is fixed. Investors can calculate the cash flows arising through coupon payments in advance over the maturity period of these bonds. These bonds also come with fixed frequency such as annual, semi-annual, or quarterly coupon payments.
Maturity Date
It is the date on which the investor can redeem the principal payment.
Investors can be assured of fixed income and principal repayment at maturity with these bonds. As such, there are special features or terms attached to these bonds that can affect the income or repayment of the principal.
Special Considerations with Plain Vanilla Bond
Despite the simplicity, plain vanilla bonds offer several special benefits to investors and issuers. For instance, investors can calculate the cash flows arising through coupons over the lifetime of a plain vanilla bond. It provides consistency and secured income for investors.
Plain vanilla bonds are easily tradable securities. Without complex features, these bonds can be easily sold or bought in the market. Hence, investors enjoy the liquidity of these bonds as an added advantage.
The drawback of these bonds comes through the fixed coupon rate. Investors can be at a disadvantage with the rising interest rate market.
Example
Suppose a bond is issued with a 5% coupon rate semi-annually and 10 years of the maturity date. The face value of the bond is $1,000.
The investor will receive two coupon payments = 1,000 * 2.5% = $25 semi-annually or $50 annually. The principal can be redeemed at maturity at par or face value of $1,000.
Note: Bond Issuers can offer a discount on the face value of the bond to set a lower issue price. For instance, in our example, the bond can be issued at a discounted issue price of $950.
Advantages of Investing in a Plain Vanilla Bond
Plain vanilla bonds can offer several advantages to investors and issuers.
- These bonds offer a stable income for investors and do not come with any complicated terms and conditions.
- Vanilla bonds are easily tradable, hence offer good liquidity.
- These can be good investment instruments in a volatile interest rate market.
- These bonds offer stability for investors and issuers alike.
Disadvantages of Investing in a Plain Vanilla Bond
Despite the simplicity, these bonds offer some limitations as well.
- Investors can be at a disadvantage in rising interest rate markets.
- Issuers cannot call and investors cannot use the put feature with these bonds.
- With increasing interest rates, these bonds can lose value in the market.
Conclusion
Plain Vanilla bonds are the most basic type of bonds. These bonds do not come with any special features. The coupon rate, maturity date, and face value of these bonds are fixed. Investors can enjoy consistent and stable income with these bonds.
