It is important to understand bond terms for any investor who plans to include bonds in his investment portfolio. The example of bond terms includes coupon rate, face value, maturity, yield, duration, and credit rating. Knowing these terms will allow any beginner investor to be more informed about bonds' issues, quotations, and investments.
This article gives the definition of some of the most popular bond terms.
Bonds are debt securities. The lender gets money from the investors on agreed terms. The government, municipality, company, or any other institution can take a loan and pay back the interest along with the principal amount of money.
Bonds can be bought either at issue or in the secondary market. If bonds are held until maturity, they will be paid back at face value. Otherwise, they can be sold at prices that may be more or less than their face value.
This is a practical bond glossary of common bond terms explained.
The issuer is the party that borrows funds through the use of the bond. Issuers range from the federal government, municipalities, government agencies, and corporations.
It is important to know the issuer because repayment of interest and principal is dependent on the financial soundness of the issuer. The characteristics of a corporate bond would be different from those of a Treasury security because a corporate bond has credit features about the issuing company, and a Treasury security is issued by the government.
Face value refers to the amount promised to the bondholder upon reaching maturity, provided the issuer fulfills the promise. It is also referred to as par value.
For individual bonds, the face value usually ranges from $1,000. The face value should not be confused with the price at which an investor purchases a bond in the secondary market. For instance, a $1,000 bond could be traded for $950 or $1,050 depending on the market.
The maturity date refers to the day when the bond becomes mature according to its predetermined term. When the bond matures, the issuer usually redeems the nominal value of the bond.
Maturity is an important concept for investors because it gives them the idea of how long their investment will remain invested. Bonds with different terms tend to behave differently with changes in interest rates.
The coupon rate is the annual rate of interest of the bond, as a percent of face value. A bond valued at $1,000 with a 5% coupon rate earns an annual coupon payment of $50.
The coupon rate is determined on the basis of the terms of the bond and remains the same irrespective of changes in market interest rates for a normal fixed-rate bond. Nevertheless, the market price and yield of the bond will vary.
The coupon payment is the amount of money received by the bondholders from the interest earned. Thus, if there is a bond worth $1,000 with a 6% annual coupon rate, then $60 worth of interest is earned. If there are semiannual payments made, then $30 is paid out each time.
The issue price refers to the price that the investors would pay at the time of issuance of the bond. It may be equal to the face value, although the two do not have to necessarily be equal. The bond may be sold for a different price after issuance in the secondary market.
This is the market where investors engage in buying and selling bonds already issued. This is significant in that the price of a bond already issued may fluctuate while the initial coupon rate remains unchanged. One of the factors that affect bond prices is the market interest rate.
Knowing about the various aspects of bond valuation becomes even more crucial when considering a comparison between a bond’s initial attributes and the bond’s current value.
Market price refers to the price at which the investor will most likely buy a bond from the secondary market or sell it based on the situation of the market and the transaction. The market price of a bond could either be higher than, lower than, or equal to the bond’s face value.
A bond is said to trade at a premium when the price of the bond is higher than its face value.
If a bond of a face value of $1,000 is trading at $1,050, then the investor is paying more than what the issuer is expected to repay at maturity. The premium could be due to the high desirability of the coupon of the bond compared to current market interest rates.
A bond is said to trade at a discount when its price is lower than its face value.
For instance, a $1,000 bond is trading at $950; then it is trading at a discount of $50. Some of the reasons that may cause a discount include increases in market interest rates relative to the bond coupon.
Current yield calculates a bond’s annual interest payment against its current market price.
For instance, when a bond earns an annual interest of $50, and the current price is $950, the current yield is approximately 5.26%. However, the coupon rate will remain unchanged at 5% if the bond has a face value of $1,000. This shows the importance of using these terms interchangeably.
The yield to maturity is often referred to as the YTM and gives the estimated annualized return that one would get from purchasing a bond at the prevailing market price and holding it to maturity, provided the bond pays as planned.
YTM takes into account the cost of purchase, coupon payments, par value, and the period until maturity of the bond. Since it takes into account more factors compared to other measures such as coupon rate and current yield, it is widely used in comparisons between bonds.
YTM is an estimate and not necessarily the total return on investment due to taxes, transaction costs, changes in the reinvestment rate, and the likelihood of not holding the bond to maturity.
The Yield to Call (YTC) is the yield calculated on a callable bond. The calculation involves the assumption of an exercise of the issuer’s right to redeem the bond on a certain call date instead of letting the bond reach its maturity.
This is important, as one might expect to receive interest payments on their investments for a period of many years, while in the case of a callable bond, the bond could be redeemed before its maturity.
The measure called yield to worst (YTW) is especially helpful in valuing callable bonds, as it uses the smallest possible yield for the corresponding redemption scenario, which may include yield to maturity and yield to call.
In case the investor analyzes the callable bond, only taking into account the yield to maturity may give an incomplete picture of the situation.
Apart from price and yield, there are other terms relating to bond investment that affect the potential success of an investment.
Credit risk is the risk of default by the issuer who fails to make payment of either interest or principal at maturity.
Credit risk differs with issuers. The credit risk of corporate bonds, for instance, depends on the financial health of the issuer company. Investors may use credit ratings as one of the tools in determining the quality of credit even though they are just opinions and not guarantees of repayment.
Credit rating refers to the evaluation of the creditworthiness of the bond/issuer made by a credit rating agency.
The ratings may assist investors to differentiate the level of credit quality. There are investment-grade and high-yield bonds, which occupy different ends of the spectrum depending on their credit quality and hence their returns. Investors should not solely depend on the rating.
Investment-grade bonds are those securities that satisfy certain rating criteria that suggest better credit quality.
These bonds include government, municipal, agency, and corporate bonds. The term is used for credit quality and not for those bonds that generate a positive return or suit all investors.
High-yield bonds are those bonds whose credit ratings are worse than those of the investment-grade bonds.
As a result, there are chances that higher credit risk will be linked to such bonds. These bonds may provide higher yields because of higher credit risk. Higher yield does not mean a better investment.
Interest rate risk is the chance that changes in market interest rates can affect the market value of a bond.
For normal fixed-interest-rate bonds, price is usually negatively related to the market interest rates. When interest rates increase, bonds with relatively low interest rates will not be as popular, and thus their prices will decrease. When interest rates decrease, bonds with relatively high interest rates will be more popular, and thus their prices may increase.
Duration measures how sensitive a bond is to changes in interest rates. In general, bonds with relatively high duration are more sensitive to interest rates than bonds with relatively low duration.
Also Read: Bond Duration vs. Maturity: A Detailed Guide for Beginners
The risk of liquidity means that the investor would be unable to convert the bond into cash on time and at the price at which the bond was worth.
Not all bonds are equally liquid. Low liquidity may lead to difficulties in buying or selling and might have some impact on the selling price.
Inflation risk is the risk associated with the possibility of the purchasing power of the bond decreasing due to higher prices.
For instance, having a $50 coupon might lose some purchasing power with the increase in inflation over the years.
Reinvestment risk is the possibility that coupon payments or principal returned to the investor will have to be reinvested at lower interest rates.
This can be especially important when market rates decline. An investor may continue receiving the original coupon from a bond but find that new investments available for those coupon payments offer lower yields.
Call risk applies to callable bonds. A callable bond gives the issuer the right to redeem the security before its stated maturity under specified conditions.
An issuer may choose to call a bond when market interest rates have fallen, allowing it to refinance its debt at a lower rate. For the investor, an early redemption can mean losing future coupon payments and having to reinvest the returned principal at potentially lower rates.
The call date is the first date upon which the issuer is able to exercise its right to call back the bond, provided that the bond terms allow for the same.
Bonds may have more than one call date. Investors need to consult the prospectus and not assume that the maturity date is the earliest date for redemption.
The call price is the price paid by the issuer when a bond is redeemed. This could be equal to face value or even a call premium depending on the terms of the bond and timing of call.
Accrued interest refers to the interest that has been built up since the last coupon date.
In situations where there is a purchase or sale of bonds between two coupon dates, the transaction normally takes into account the accrued interest. Knowledge of accrued interest will assist investors in separating the price of the bond from the transaction amount.
The common bond terms above can apply to many types of bonds, but the underlying risks and tax considerations can differ.
Treasury securities are those that are issued by the government of the United States. Treasury bonds are considered long-term securities, whereas Treasury notes have a short-term maturity period.
There are many terms associated with the evaluation of Treasury securities, like coupon, maturity, yield, price, and duration.
These types of bonds are issued by various state governments, municipalities, and local authorities for financing their public undertakings.
Tax benefits may be one of the unique qualities of these bonds; however, there are different types of tax benefits based on the security and the individual investor.
Corporate bonds are those bonds issued by corporations as a means of raising money. Their terms can vary greatly depending on the issuer, credit quality, maturity, coupon, security, and call features.
Credit risk is one of the major factors that need to be kept in mind by corporate bond investors, since payment will depend upon the issuer’s ability to pay back.
The coupon rate of a fixed-rate bond is fixed in accordance with its terms. It ensures scheduled interest payments at a known rate, but its market price may fluctuate depending on the market interest rate.
Interest paid on the floating-rate bond is allowed to be reset from time to time using some pre-defined benchmark or reference rate.
Since the coupon payment can vary, floating-rate bonds react in different ways as compared to traditional fixed-rate bonds whenever there is a fluctuation in market rates. The particular reset methodology, along with the reference rate, forms the key components of the bond.
The zero-coupon bond does not have any coupon payment. Instead, they are usually sold below par and pay par at maturity.
For instance, a zero-coupon bond may be purchased at a price below $1,000, and the par value of $1,000 will be received at maturity, provided that the issuing company pays its dues.
A secured bond uses a specific piece of collateral, whereas an unsecured bond depends on the overall credit rating of the issuer.
This becomes especially crucial in case the issuer goes into financial trouble or bankruptcy, as different creditors will have claims to the assets.
Also check: What are Short-Term vs Long-Term Bonds
Bond terminology does not mean a lot of definitions to be memorized. In fact, the value lies in comprehending relationships between them.
The face value shows what the issuing party normally agrees to repay at maturity. The coupon rate is the interest rate, whereas the coupon payment is the actual dollar amount. The market price is the current worth of the bond, and yields will show its relation to price and payments.
At the same time, credit risk, interest rate risk, duration, liquidity, inflation, and the call provision are factors that make two bonds with a similar coupon rate different.
For beginners trying to understand bond listings, the most effective strategy is to analyze each listing as a whole and not focus on just one interesting characteristic.
Not necessarily. The coupon rate is set based on the bond's agreement and is normally determined based on the face value. On the other hand, the yield can be affected by the bond's market price, as well as cash flows included in the measure of yield.
With regular fixed-interest rate bonds, the price of the bond will fall as a result of rising interest rates since new bonds become more competitive. The impact may be higher with more sensitive bonds or higher duration bonds.
A callable bond means that the bond can be redeemed before its maturity, which results in stopping the payment of coupons sooner than expected. If interest rates are already low, then an investor will have to reinvest the money at lower interest rates.
YTM estimates the return associated with holding a bond until maturity, while YTC considers an applicable call date and call price. For callable bonds, both measures can be relevant because the bond may be redeemed before maturity.
No. Yield should be considered alongside credit quality, maturity, duration, liquidity, call provisions, price, taxes, and the investor’s objectives. A higher yield can reflect greater risk rather than simply a better opportunity.
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