Key financial jargon you need to know for successful investment in bonds – Part I
Most investors are well aware that bonds are debt instruments, which historically have had lower returns than equities, but are usually less volatile, and entail less risk. A balanced financial portfolio, whether applied to savings or a pension fund product, will nearly always hold both equities and bonds. This is in order to target capital appreciation from stocks, together with a certain degree of downside protection provided via the bonds.
At first glance, bonds, and the role of bonds in a portfolio, might therefore seem straightforward. But, in fact, there is a fair amount of financial jargon associated with bonds, and any investor wanting to make better overall investment decisions, is well advised to get fully on top of it. In Part 1 of this 2 part article series, we explain the jargon frequently used when discussing bond markets in general. In Part 2 we explain the different kinds of bonds available for investment.
1. Accrued interest – is the estimated unpaid interest earned from an investment in a bond (or any other kind of similar asset).
2. Auction – A process of public sale of Treasury Securities where the rate or yield is determined by sealed bid.
3. Basis point – is the smallest measure used to represent a bond yield. One basis point equals 0.01% of yield.
4. Bill – A debt instrument with a maturity period of not more than one year, and issued by the US Treasury.
5. Bond insurance – is a legal commitment by an insurance company guaranteeing the payment of interest and principal, in a case of default by the issuer.
6. Benchmark – A bond, the terms of which are used for comparison with other bonds of identical maturity. US Treasury bonds are often used as benchmarks for global comparisons.
7. Bond swap – is the process of selling a bond and purchasing another of similar market value. This is usually done for tax purposes, to upgrade credit quality, or to increase or reduce the maturity period, etc.
8. Call date – is the date at which a bond can be redeemed by the issuer, before the maturity date.
9. Call premium – is the extra dollar amount paid by the bond issuer for calling a bond prior to the maturity date. The dollar amount, also referred to as premium or penalty, is expressed as a percentage of the principal amount.
10. Call price – is the price paid to redeem a bond before maturity. The issuer will usually purchase the bond at a premium or at par.
11. Call protection – A condition which curtails the right of the issuer to call a bond for a specified number of years.
12. Call risk – Indicates the risk of a bond being called before the maturity date due to a decline in interest rates. Ultimately, investors may have to re-invest at lower interest rates.
13. Cap – is the maximum payable interest on a floating rate bond.
14. Floor – is the minimum payable interest on a floating rate bond.
15. Forward cap – Commitment to enter into a cap at a future date.
16. Forward floor – Commitment to enter into a floor at a future date.
17. Forward swap – Commitment to enter into a swap at a future date.
18. Closing date – The last specified date for a new bond issue.
19. Collar – is the minimum and maximum (floor and cap) permissible interest rate for a floating rate bond.
20. Coupon rate – reflects a bond’s interest rate. The coupon rate is expressed as a percentage of the bond’s face value. Normally, the rate payable on a semi-annual basis is indicated.
21. Current yield – is the yield calculated based on the current market price of the bond. For example, a bond paying an annual interest of $8, and trading at a price of $100, is said to have a current yield of 8%.
22. CUSIP – A uniform method applied globally for easy identification of bonds. The acronym stands for Committee on Uniform Security Identification Procedures. Each and every bond issued will have a unique CUSIP number consisting of nine alphanumeric characters.
23. Denomination – The face value of a bond, which the issuer promises to pay upon maturity.
24. Downgrade risk – The risk of a bond being downgraded by the rating agencies.
25. New-issue market – The market for new issues of bonds and notes.
26. Odd lot – represents a tranche of bonds worth $100,000 or less.
27. Par amount – Also referred to as par value, is the principal amount of a bond payable at maturity.
28. Redemption – is the process of buying back bonds by the issuer at or before the maturity date.
29. Secondary market – is the market where the bonds issued in the primary market change hands on an ongoing basis.
30. Senior Securities – In the event of liquidation or bankruptcy of a company, Senior Securities (bonds or notes) will have higher priority on the income or assets of the organization. This means the holders will get repaid ahead of the holders of Junior Securities.
31. Spread to Treasury – The difference between the yield from a fixed-income bond issued by a private enterprise, and the yield on a Treasury security of similar maturity period.
32. Subordinated debt – A bond or note which gets priority for repayment of principal and interest only after the senior debt is fully (principal plus interest) serviced.
33. Transfer agent – A third party appointed by a bond issuer for maintaining ownership records.
34. Yield curve – A graphical representation of the yield and maturity of different bonds having similar credit ratings.
35 Yield spread – is the difference in the yield between two bonds.
36. Yield to call – refers to a security’s yield calculated with an assumption that the interest payments will be made on time until the call date.
37. Yield to maturity – refers to a bond’s yield calculated on the assumption that the interest payments will be made on time through until the maturity date.
38. Yield to worst – refers to the lowest yield from a bond. For example, if the yield to call is lower than the yield to maturity, then the former is considered the yield to worst.