The Language of Bonds
Like many subject areas, bond investing involves terminology that can be a key to understanding the subject. Here are some basic terms that may help you become a more informed bond investor.
Issuer. The entity that is borrowing money by selling the bond. The issuer might be a corporation or a federal, state, or local government agency.
Par or face value. The value of a bond when issued; i.e., the principal that the issuer agrees to repay on the maturity date (as long as the issuer does not default). A $1,000 bond has a par of $1,000.
Coupon. The annual interest rate that the issuer pays in return for the loan. Typically, half of the coupon rate is paid every six months.
Maturity date. The date on which the issuer promises to repay the loan (principal) in full. Bond maturities generally range from 30 days to 30 years.
Yield or current yield. The interest rate of a bond in relation to its price. At the time of initial purchase, the yield is generally the same as the coupon rate. If Investor A buys a $1,000 bond for $1,000 with a coupon rate of 5% per year, the yield is 5% ($50 annually). However, if Investor A wants to sell the bond on the secondary market before the maturity date, he or she may sell at a higher price (premium) or a lower price (discount) depending on the interest rate environment at the time of the sale.
For example, if interest rates have gone up, and Investor B could buy a newly issued $1,000 bond with a coupon rate of 6% ($60 annually), Investor A might have to sell the bond at a discount for $833 or less. That would give Investor B a yield of 6% ($50 annually on 5% coupon ÷ market price $833 = 6%). If rates have gone down, Investor A would likely be able to sell the bond at a premium.
Yield to maturity (YTM). The total return from a bond that is held to maturity, based on its par value, coupon rate, price, duration (see below), and compound interest that could be earned by reinvesting coupon payments. Although YTM is calculated over the remaining life of the bond, it is expressed as an annual rate.
Duration. A measure of how many years it will take for an investor to recoup the bond’s price from the bond’s total cash flows. Duration is often used as an approximate measure of a bond’s sensitivity to interest rates. As discussed above, when interest rates rise, bond prices typically fall, and vice versa. To estimate the impact of a rate change, multiply a bond’s duration by the expected percentage change in interest rates. For example, if interest rates rise 1%, a bond with a seven-year duration might be expected to lose roughly 7% in value. A bond with a three-year duration might lose 3% in value.
These are fundamental concepts, but many other terms apply to bond investing. The principal value of bonds will fluctuate with changes in market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher yields also involve a higher degree of risk.