Chapter 7 Bond Definitions & Risks

Yield to Maturity (YTM)

- The rate of return that a bondholder will earn if they buy the bond and hold it to maturity - The discount rate that equates the present value of the bonds coupon payments and face value with the bond's price - Investors required rate of return on a bond investment expressed as an APR (e.g, if the bond is a semiannual bond, if we calculate the rate per semiannual period then we simply double it to obtain and APR).

Sinking Fund

Account used by the trustee to call bonds or repurchase them in the open market.

Dirty Price

Bond price with interest accrued since the last coupon payment date. This is what will actually be paid for the bond.

Clean Price

Bond price without accrued interest (the price as of a coupon payment date). This is the price that will be quoted by a bond dealer, in the financial press, etc.

Junk Bonds (High-Yield Bonds)

Bonds rated BB or below. They are issued by firms with questionable ability to make their promised payments (or issued by firms that experience financial difficulty after they issued their bonds).

Mortgage Bonds

Bonds secured by a lien on specific assets of the issuing firm, such as real estate (just like a home mortgage is secured by a lien on the home).

Subordinated Debenture

Debentures (unsecured bonds) that take a lower (subordinate) position in claiming the assets of the bond-issuing firm in the event of liquidation as compared to unsubstantiated debt.

Bond Rating

Judgement's about the future risk (likelihood of default) of the bond in question. Bond Ratings are extremely important in helping bond market participants determine the cost of the funds (interest rate on debt) for the issuing firm. Three primary rating agencies exist - Moody's, Standards & Poor's, and Fitch Investor Services.

Maturity

Length of time until the end of a bond's life, or the specific calendar date on which the bond ends (a bond pays out its par value at maturity).

Bond

Long-term debt issued by corporations, governments, etc. A promise to repay an amount at the end of the bond's life (plus periodic interest along the way, in the case of the coupon bonds).

Coupon (Interest) Rate

Percentage of a bond's face value that is paid out over the course of each year in the form of periodic interest payments. Does not change over the Bond's life except in the case of floating rate bonds.

Coupon Payment

Periodic Interest payments. Each payment equals the total coupon payments for the year (coupon rate times par value) divided by number of coupon payments per year. A 9% coupon rate and $1,000 par value would result in $90 annual coupon payments, or two $45 semiannual coupon payments per year

Discount Bond

Price < Par Value

Par Value Bond

Price = Par Value (typically $1,000)

Premium Bond

Price > Par Value

Default Risk

Risk that all promised principal and interest payments will not be made by the issuing firm (the issuer will default). Only U.S. Government bonds and bills are deemed to be free of default risk.

Inflation Risk

Risk that interest rates will rise (and thus, bond prices will fall) because of unanticipated inflation (remember, inflation drives nominal interest rates up).

Interest Rated Risk

Risk that interest rates will rise, causing a bondholder's investment to decline in value (cash flows are discounted at the now higher rate; more attractive yields are now available in the marketplace, causing previously-issued bonds to now be relatively less attractive). Note: This may partially be caused by changes in inflation;see inflation risk.

Reinvestment Risk

Risk that lower interest rates will cause a bondholder to have to invest the coupon payments that they receive at a now lower interest rate; this effect is opposites to interest rate risk (they partially offset one another).

Currency Risk

Risk that the currency in which a bond investment is denominated will decline versus your home currency (if you invest in bonds that pay coupons and par value in Yen, you face the risk that the Yen will decline versus the dollar).

(Lack of) Marketability (or Liquidity) Risk

Risk that you can't sell a bond prior to its maturity easily. Most bonds are traded over the counter; since they are not traded on exchanges, their price might have to be lowered in order to sell them quickly.

Maturity Date

Specific date on which the bond matures (ends) and the par value is paid along with the final coupon payment, if any.

Par or Face Value

The amount that will be repaid by the firm at the end of the bond's life, which is usually $1,000.

Bid-Ask Spread

The bid price is the price that a dealer will pay for a security, while the ask price is the price that the dealer is asking (will take) for a security. The spread is the difference (ask price-bid price).

Call Provisions

The issuer has the right to purchase (call) a bond at a specified price. The issuer is more likely to call bonds when interest rates have fallen, as they can issue bonds at a lower rate.

Indenture

The legal agreement between the firm issuing the bonds and the bond trustee who represents the bondholders. It provides the specific terms of the bond agreement such as the rights and responsibilities of both parties.

Real Interest Rate

The percentage change in the purchasing power (roughly nominal rate - expected inflation).

Nominal (quoted) Interest Rate

The percentage increase in the number of dollars

Current Yield

Total coupon for the year divided by (expressed as a percentage of) the bond's current market price.

Debenture

Unsecured Long-Term Debt (bonds with no specific assets pledged as collateral to secure them).

Euro Bonds

bonds issued in a country different from the one in whose currency the bond is denominated; for instance, a bond issued in Europe, Asia, or anywhere except in the U.S., that pays interest in principal in U.S. dollars is a Euro Bond. They are often called Eruodollar Bonds.

Zero Coupon Bonds

bonds that make no periodic coupon payments. They only make one payment to the bondholder, and that is at the end of the bonds life. In order for the investor to earn a return, they are sold for less than the amount that they pay back at the end.