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Bond Basics

Glossary

Accrued interest

Interest deemed to be earned on a security but not yet paid to the investor.

Ask price (or Offer price)

The price at which a seller offers to sell a security.

Average life

On a mortgage security, the average length of time that each principal dollar is expected to be outstanding, based on certain assumptions about prepayment speeds.

Basis point

One one-hundredth (.01) of a percentage point. For example, eight percent would be equal to 800 basis points.Yield differences are often quoted in basis points (bps).

Bearer bond

A physical bond that does not identify its owner and is presumed to be owned by the person who holds it. In the United States, it has not been legal to issue bearer bonds in the municipal or corporate markets since 1982. As a result, the only bearer bonds that still exist in the secondary market are long-dated maturities issued prior to 1982, which are becoming increasingly scarce. Among the disadvantages of bearer securities are that you must actually clip the coupons and present them to the issuer's trustee in order to receive your interest; and if the bonds are called, you will not automatically be alerted by the issuer or trustee as they do not know who the owners are.

Bid price 

The price at which a buyer is willing to purchase a bond.

Bond fund

An investment vehicle, which invests in a portfolio of bonds that is professionally managed. Types of bond funds include open-ended mutual funds, closed-end mutual funds, and exchange traded funds.

Bond insurers and reinsurers

Specialized insurance firms serving the fixed-income market that guarantee the timely payment of principal and interest on bonds they insure in exchange for a fee.

Bond swap

The sale of a block of bonds and the purchase of another block of similar market value.

Book-entry

A method of recording and transferring ownership of securities electronically, eliminating the need for physical certificates.

Bullet bond / Bullet maturity

A bond that pays regular interest, but that does not repay principal until maturity.

Callable bonds

Bonds that are redeemable by the issuer prior to the maturity date, at a specified price at or above par.

Call premium

The dollar amount paid to the investor by the issuer for exercising a call provision that is usually stated as a percent of the principal amount called.

Cap

The maximum interest rate that may be paid on a floating-rate security.

Closed-end mutual fund

A fund created with a fixed number of shares which are traded as listed securities on a stock exchange.

Collar

Upper and lower limits (cap and floor, respectively) on the interest rate of a floating-rate security.

Compound interest

Interest that is calculated on the initial principal and previously paid interest.

Convertible bond

A corporate bond that can be exchanged, at the option of the holder, for a specific number of shares of the company's stock. Because a convertible bond is a bond with a stock option built into it, it will usually offer a lower than prevailing rate of return.

Coupon

A feature of a bond that denotes the amount of interest due, and the date payment will be made.

Coupon payment

The actual dollar amount of interest paid to an investor. The amount is calculated by multiplying the interest of the bond by its face value.

Coupon rate

The interest rate on a bond, expressed as a percentage of the bond's face value. Typically, it is expressed on a semi-annual basis.

Credit rating agency

A company that analyzes the credit worthiness of a company or security, and indicates that credit quality by means of a grade, or credit rating.

Current yield

The ratio of the interest rate payable on a bond to the actual market price of the bond, stated as a percentage. For example, a bond with a current market price of par ($1,000) that pays eighty dollars ($80) per year would have a current yield of eight percent.

CUSIP

The Committee on Uniform Security Identification Procedures was established by the American Bankers Association to develop a uniform method of identifying securities. CUSIP numbers are unique nine-character alphanumeric identifiers assigned to each series of securities.

Dated date (or Issue date)

The date of a bond issue from which a bond begins to accrue interest.

Default

A failure by an issuer to: (i) pay principal or interest when due, (ii) meet non-payment obligations, such as reporting requirements or (iii) comply with certain covenants in the document authorizing the issuance of a bond (an indenture).

Discount

The condition under which the par value of a bond exceeds its market price. For example, a $1,000 par amount bond, which is valued at $980 would be said to be trading at a 2% discount [($1000-$980)/$1000=2%].

Discount note

Short-term obligations issued at a discount from face value, with maturities ranging from one to 360 days. Discount notes have no periodic interest payments; the investor receives the note’s face value at maturity. For example, a one year, $1,000 face value discount note purchased at issue at a price of $950, would yield $50 or 5.26 percent ($50/$950).

Discount rate

The interest rate the Federal Reserve charges on loans to member banks.

Duration

The weighted maturity of a bond's cash flows, used in the estimation of its price sensitivity for a given change in interest rates.

Embedded option

A provision that gives the issuer or the bondholder an option, but not the obligation, to take an action against the other party. The most common embedded option is a call option, giving the issuer the right to call, or redeem, the principal of a bond before the scheduled maturity date.

Exchange-traded fund

A fund that tracks an index, a commodity or a basket of assets. It is passively-managed like an index fund, but traded like a stock on an exchange, experiencing price changes throughout the day as they are bought and sold. Bond ETFs like bond mutual funds, hold a portfolio of bonds and can differ widely in their investment strategies.

Extension risk

The risk that investors' principal will be committed for a longer period of time than expected. In the context of mortgage- or asset-backed securities, this may be due to rising interest rates or other factors that slow the rate at which loans are repaid.

Face (or Par value or Principal value)

The principal amount of a security that appears on the face of the instrument.

Federal funds rate

The interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. The target federal funds rate is set by the Federal Reserve Board's Federal Open Market Committee and is a principal tool of monetary policy. For more information, see www.federalreserve.gov.

Fixed rate bond

A long-term bond with a set interest rate to maturity.

Floating-rate bond (or Variable rate bond or Adjustable rate bond)

A bond whose interest rate is adjusted periodically according to a predetermined formula; it is usually linked to an interest rate index such as LIBOR.

Floor

The lower limit for the interest rate on a floating-rate bond.

Future value

The value of an asset at a specified date in the future, calculated using a specified rate of return.

General obligation bond

A municipal bond secured by the pledge of the issuer’s full faith, credit and taxing power.

High grade bond

See Investment-grade bond.

High-yield bond (or junk bond)

Bonds rated Ba (by Moody's) or BB (by S&P and Fitch) or below, whose lower credit ratings indicate a higher risk of default. Due to the increased risk of default, typically issued at a higher yield than more creditworthy bonds.

Investment-grade bond (or high grade bond)

Bonds rated Baa (by Moody's) or BBB (by S&P and Fitch) or above, whose higher credit ratings indicate a lower risk of default. These bonds tend to issue at lower yields than less creditworthy bonds.

Issue date
See Dated date.
Issuer

The entity obligated to pay principal and interest on a bond it issues.

Interest

Compensation paid or to be paid for the use of assets, generally expressed as a percentage rate of par.

Junk bond

See High-yield bond.

LIBOR (London Interbank Offered Rate)

The interest rates banks charge each other for short-term eurodollar loans. LIBOR is frequently used as the base for resetting rates on floating-rate securities.

Liquidity (or marketability)

A measure of the relative ease and speed with which a security can be purchased or sold in a secondary market.

Marketability

See Liquidity.

Maturity

The date when the principal amount of a security is due to be repaid.

Mortgage-backed bonds or securities (MBS)

Mortgage-backed securities, called MBS are bonds or notes backed by mortgages on residential or commercial properties—an investor is purchasing an interest in pools of loans or other financial assets. As the underlying loans are paid off by the borrowers, the investors in MBS receive payments of interest and principal over time. The MBS market is for institutional investors and is not suitable for individual investors.

Mutual fund (or Open-end fund) 

Investment companies that invest pooled cash of many investors to meet the fund’s stated investment objective. Mutual funds stand ready to sell and redeem their shares at any time at the fund’s current net asset value: total fund assets divided by shares outstanding.

Non-callable bond

A bond that cannot be called for redemption by the issuer before its specified maturity date.

Offer price

See Ask.

Offering document (Official statement or Prospectus) 

The disclosure document prepared by the issuer that gives in detail security and financial information about the issuer and the bonds or notes.

Official statement

See Offering document.

Open-end mutual fund

See Mutual fund.

Par value

See Face.

Paying agent

The entity, usually a designated bank or the office of the treasurer of the issuer, that pays the principal and interest of a bond.

Premium

The amount by which the price of a bond exceeds its principal amount.

Prepayment

The unscheduled partial or complete payment of the principal amount outstanding on a loan, such as a mortgage, before it is due.

Prepayment risk

The risk that principal repayment will occur earlier than scheduled, forcing the investor to receive principal sooner than anticipated and reinvested at lower prevailing rates. The measurement of prepayment risk is a key consideration for investors in mortgage- and asset-backed securities.

Present value

The current value of a future payment or stream of payments, given a specified interest rate; also referred to as a discount rate.

Primary market

The market for new issues.

Principal

See Face.

Prospectus

See Offering document.

Ratings

Designations used by credit rating agencies to give relative indications as to opinions of credit quality.

Registered bond

A bond whose owner is registered with the issuer or its agent. Transfer of ownership can only be accomplished if the bonds are properly endorsed by the registered owner.

Reinvestment risk

The risk that interest income or principal repayments will have to be reinvested at lower rates in a declining rate environment.

Revenue bond

A municipal bond payable from income derived from tolls, charges or rents paid by users of the facility constructed with the proceeds of the bond issue.

Risk

The measurable probability that an actual return will be different than expected. There are many types of risk such as market risk, credit risk, interest rate risk, exchange rate risk, liquidity risk, and political risk.

Secondary market

Market for issues previously offered or sold.

Secured bond

A bond that is backed by collateral.

Senior bond

A bond that has a higher priority than another bond's claim to the same class of assets.

Settlement date

The date for the delivery of bonds and payment of funds agreed to in a transaction.

Sinking fund

Money set aside by an issuer of bonds on a regular basis, for the specific purpose of redeeming debt. Bonds with such a feature are known as "sinkers."

Subordinated bond 

A bond that has a lower priority than another bond's claim to the same assets.

Trade date

The date upon which a bond is purchased or sold.

Transfer agent

The party appointed by an issuer to maintain records of bondholders, cancel and issue certificates, and address issues arising from lost, destroyed or stolen certificates.

Trustee

An institution, usually a bank, designated by the issuer as the custodian of funds and official representative of bondholders. Trustees are appointed to ensure compliance with the trust indenture and represent bondholders to enforce their contract with the issuers.

Unit investment trust

An investment fund created with a fixed portfolio of investments to provide a steady, periodic flow of income to investors.

Unsecured bond

A bond that is not secured by collateral.

Yield

The annual percentage rate of return earned on a bond calculated by dividing the coupon interest rate by its purchase price.

Yield curve

A line tracing relative yields on a type of bond over a spectrum of maturities ranging from three months to 30 years.

Yield to call

A yield on a bond calculated by dividing the value all interest payments that will be paid until the call date, plus interest on interest, by the principal amount received on the call date at the call price, taking into consideration whatever gain or loss is realized from the bond at the call date.

yield to call

Example: You pay $900 for a five year bond with a face value of $1,000. The bond pays an annual coupon of ten percent. This bond is called at year three for $1,100.

The yield to call of this bond is 18.4 percent. This reflects the three years of coupon payments and the difference between the price paid and the call price. Had the bond not been called, the yield to maturity would have been 12.8 percent. Bond calculators may be found at this web site.

Yield to maturity

A yield on a bond calculated by dividing the value of all the interest payments that will be paid until the maturity date, plus interest on interest, by the principal amount received at the maturity date, taking in to consideration whatever gain or loss is realized from the bond at the maturity date.

yield to maturity

Example: You pay $900 for a five year bond at a face value of $1,000. The bond pays an annual coupon of ten percent.

Here the yield to maturity is 12.8 percent. This reflects the coupon payments and the difference between the price and the face value of the bond. Bond calculators may be found at this web site.

Zero-coupon bond

A bond which does not make periodic interest payments; instead the investor receives one payment, which includes principal and interest, at redemption (call or maturity). See Discount note.