Fixed Income (Bond) Terminology
The idea of owning a bond as an investment is an easy concept to understand. However, it is important to know the terms used in bond investing. For example, if you come across an attractive bond, and the broker quoted you a yield. There is a significant difference when it comes to investment returns for different yield and different type of bonds. Here are the important terms that every bond investor should know.
The idea of owning a bond as an investment is an easy concept to understand. However, it is important to know the terms used in bond investing. For example, if you come across an attractive bond, and the broker quoted you a yield. There is a significant difference when it comes to investment returns for different yield and different type of bonds.
Here are the important terms that every bond investor should know.
Basis Point – A basis point is equal to one-hundredth of a percentage point, or 0.01%. In other words, if the 10-year Treasury bond yield is 5% and you hear that it went up by 12 basis points, that means that it rose to 5.12%.
Bond Quality – A rating given to bonds that indicates their respective issuer’s creditworthiness. The three primary rating agencies are Standard & Poor’s, Moody’s, and Fitch.
The rating agency rates the bond issuer on its financial strength and/or its ability to repay the bond’s principal and interest. For example, Standard & Poor’s will issue ratings found on the schedule below:
AAA High Grade
AA+ to AA- Upper / Medium Grade
A+ to A- Medium Grade
BBB+ to BBB- Lower / Medium Grade
BB+ to BB- Non Investment Grade / Speculative
B+ to B- Highly Speculative
CCC+ to CCC- Extremely Speculative or In Default
D In Default
Bond Laddering – A portfolio management strategy that applies the basic concept of purchasing multiple bonds, each with different maturity dates, in order to achieve diversification.
Desirable outcomes of bond laddering include the following:
Decrease interest rate risk by holding both short-term and long-term bonds
Decrease re-investment risk, since, as one bond in the ladder matures, the proceeds are re-invested.
Callable Bond – A bond that can be bought back before the time when it would normally mature.
Convertible Bond – A combination some features of stocks with some features of bonds. They generally function like standard bonds but have a provision where the holder can choose to convert the bond into shares of common stock at a certain exchange rate.
Coupon Rate – the interest rate paid by the bond issuer and is based on the par value of the bond. For instance, a $1,000 bond with a 6% coupon rate would pay $60 in interest each year. This is also known as the nominal interest rate of the bond.
Duration – A measure of the sensitivity of the price of an investment to a change in interest rates. For example, if the duration of a bond (or portfolio) is 5 Years, one can assume that as interest rates decrease by 1%, the price of the bond (or portfolio) will increase by 5%. Duration, however, cannot be used as an appropriate measure of price responsiveness when the interest rates rise or fall by more than 1%. The greater the duration, the greater the interest-rate risk or greater potential reward for bonds.
Issuer – A bond’s issuer is the entity that is using the bond to borrow money, and that is responsible for paying the agreed-upon interest, and for eventually repaying the principle
Maturity – The amount of time until the principal amount of a bond is repaid, or the end of life for an investment.
Par value – The face value of the bond and is the amount the issuer promises to repay the holder upon maturity. The majority of bonds are issued with a par value of $1,000. So if you hold a 30-year Treasury bond until its maturity date, the U.S. government will give you back $1,000.
Price (Bond Price) – Price and par value are confounding one another. Price refers to how much is actually paid when a bond is purchased. For example, a company may issue bonds with a par value of $1,000 but may end up selling them at a discounted price to entice investors to buy them. Price can refer to the amount paid to buy a bond from an issuer, or from a third party.
If the asking price is lesser than the par value, it is said to be trading at a discount. For example, a bond with a $1,000 par value that sells for $950 is sold at a discount. In contrast, if the price is greater than its par value is said to be selling at a premium. A $1,000 par value bond that sells for $1,100 would have been sold at a premium.
Yield – Current indicated annual income (dividend or coupon) divided by the current price, stated as a percentage.
Yield Curve – A graphical representation of the various interest rates on a specific day of bonds having equal quality, but different maturities.
Yield to Maturity – The rate of return on a bond expected if the bond is held until maturity.
Coupon: The interest rate stated on a bond at the time it is issued. Typically, interest payments are made semiannually.
Example: A $1,000 bond with a 10% coupon will pay $100 in interest annually.
Zero Coupon Bond – A bond that is issued at a deep discount to its face value but pays no interest.
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In Brief: Here are the weekly highlights of the eventful week of early September.
Liz Truss was named as the next UK prime minister on the previous Monday, September 5, 2022, ECB raises rates by 75bps, Apple Expo — iPhone14 Event, Disney Event- D23 Expo 2022, and the passing of the longest Monarch — Queen Elizabeth II’s death marks a new era for Britain.