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This tutorial defines terms related to bonds. It is a glossary of bond terminology that covers the buying and selling of bonds, classes of bonds and bond characteristics. We have organized the definitions according to the following topics:
BOND BASICS
It is important to be familiar with the following basic terms when learning about bonds.
Bond. A debt instrument sold by a company or government
to raise money. One who buys a bond is a creditor of the company,
but not an owner, as a stockholder would be.
Indenture of trust. The legal document that details the terms of a bond, as well as the buyer's rights and responsibilities.
Basis points. A measure of differences between yields or interest rates. The unit is one one-hundredth of one percent (0.01). For example, if a bond begins with a yield of 5.50% and the yield increases over time to 5.62%, the increase is 12 basis points.
Indenture. The agreement that spells out the terms of a loan. This includes the principal, interest rate, maturity date and the rights and duties of the buyers.
Short-term. In bond maturities, one to five years.
Intermediate-term. In bond maturities, five to ten years.
Long-term. In bond maturities, more than ten years.
Legal opinion. In relation to bonds, a legal opinion is a statement declaring that a bond issue was authorized and issued. Included in the opinion is any tax-exempt status of the bonds.
Par. The value of a bond assigned by the issuer; also called face value.
Original issue discount. A bond with an offering price that is below par value.
Full faith and credit. The commitment to repay a debt backed by the creditworthiness of a bond issuer.
Coupon. A bond's interest rate.
Read below to see a few important characteristics of different sorts of bonds.
CHARACTERISTICS OF BONDS
The following terms are characteristics of bonds or include characteristics of bonds in their names.
Premium. The amount by which a security sells above its par value. If an investor buys a $1000 bond for $1030, he or she has paid a premium of $30.
Maturity. The length of time before the principal amount of a bond is due to the bondholders. It is the time until a bond may be surrendered to its issuer. Also called term-to-maturity.
Maturity date. The date on which a bond is to be redeemed and its principal and interest returned to the owner.
Callability. The feature of some bonds whereby the issuer can redeem it before it matures. Issuers often call their bonds when interest rates are falling and they want to replace high-yielding bonds with lower-yielding bonds. Call provisions must be made clear before a bond is sold. A bond with this feature is a callable bond.
Call price. The price at which a callable bond will be redeemed from bondholders. The call price is often greater than the bond's face value because the issuer may add a premium to compensate the bondholder for lost interest payments.
Convertibility. The option of exchanging a bond for a specified amount of stock. Bonds with this feature are called convertible bonds. They give the investor the option to convert the bond into stock of the issuing company. Conversion must occur at specified times, specified prices and under specified conditions, all put in writing at the time of issue.
Debenture. A bond backed by the issuer's general credit and ability to repay and not by an asset or collateral.
Investment-grade. A classification of the ability of a bond issuer to repay a bond. An investment-grade bond indicates that the bond is considered to have little risk of default.
Below-investment grade. A classification of the ability
of a bond issuer to repay a bond. A below investment-grade bond
indicates that the bond is considered to have relatively high risk
of default.
Discount bond. A bond that sells at a discounted value of its face value. If a bond has a $1000 par value but sells for $900, it is "sold at a discount" of $100. Adverse market conditions and reductions in interest rates can convince sellers to discount the bonds they sell.
Premium bond. A bond selling for more than its stated value. If a bond is $1000 par but sells for $1100, it is "sold at a premium" of $100. Market conditions and increases in interest rates can convince sellers to raise the prices of the bonds they sell.
Unsecured bond. A debt not backed by the pledge of security or collateral.
Deep-discount bond. A bond that pays little or no interest but instead sells for much less than its face value. This form of bond is a variation on the discount bond.
Now that you are familiar with many of the unique features and characteristics of different types of bonds, read below to learn about terms that describe how bonds provide income for their investors.
BOND YIELDS
This section discusses the earnings of bonds as they occur in several forms.
Yield. The rate of return on an investment, described as a percentage of the amount of the investment. For example, a bond purchased for $1,000 with a 7% yield would pay out 7% of $1,000, or $70.
Yield to maturity. The fully compounded annual rate of
return paid out over a bond's life, from purchase date to maturity,
including appreciation/depreciation and earnings. It is the most
comprehensive measure of yield.
Accrued interest. The interest that has been accumulating on a bond since the last time interest was paid on it.
Current yield. The expected rate of return calculated by dividing the most recent annualized distribution by the selling price. For example, a $2,000 par bond that pays $140 but is bought for $1600 has a current yield of 8 3/4 percent. The formula for deriving current yield is annual income divided by current price.
Coupon rate. The interest as a percent of par paid by a bond. It is called a coupon rate because historically bonds included attached coupons that were clipped and surrendered for cash. Today, most bonds come without the attached coupons.
Duration. The change in value of a bond (expressed in years) caused by a change in the prevailing interest rates. For example: For example: if a bond has a duration of 10 years and the interest rate increases by 1%, the price of the bond will decrease by 10 percent.
Floating-interest rate. A variable interest rate. One that changes periodically.
Floating-interest bond. A bond with an interest rate that changes each quarter to reflect economic conditions.
Fixed-interest bond. A bond with an interest rate that stays the same over its life span.
CORPORATE BONDS
This section discusses corporate bonds, which are bonds offered by corporations and secured by those companies' credit and/or assets.
Corporate bond. A bond issued by a corporation and backed by the company's credit and/or its assets.
Industrial bond. A bond issued to finance construction for manufacturing or commercial activity.
Collateral trust bond. A corporate bond backed by financial assets (such as a securities portfolio) of a corporation. These assets are by a third-party trustee.
Equipment trust certificate. A corporate bond secured by company equipment. Among the most common issuers are airlines and railroads that need to finance new purchases of equipment. The equipment bought may be used as collateral.
Mortgage bond. A secured corporate bond that is backed by real estate. Because mortgage bond collateral provides a clear claim on a company's assets, these bonds are considered secure and high-grade.
Junk bond. Refers to the quality of bond that is a speculative, high yielding, and issued by a company that typically finances its growth and operations with debt. Ratings companies usually assign low grades to these bonds.
Now let's take a look at Municipal bonds.
MUNICIPAL BONDS
This section discusses forms of municipal bonds as well as some related terms.
Municipal bond. A bond issued by a state or local government or its subdivisions. Municipal bonds are issued to raise money for industrial projects, housing, residential construction and general revenue. The interest earned on a municipal bond is usually free of federal income tax, and possibly of local and state taxes.
Revenue bond. A bond sold by a municipality to finance projects such as bridges, hospitals, power plants and other local services. Also called limited obligation bonds, revenue bonds are secured by the revenue generated by those projects.
General obligation bond (GO bond). An unsecured municipal bond. The payment of interest and principal are guaranteed by the taxing authority and credit worthiness of the issuer. GO bonds finance municipal operations.
Industrial-development bond. A municipal bond sold to raise money for facilities for private enterprises. These bonds attract industries to areas that need economic development.
Taxable equivalent yield. The yield one would need to receive on a taxable bond to equal the tax-free yield of a municipal bond.
MBIA-insured bonds, AMBAC-insured bonds. Municipal bonds guaranteed by either the Municipal Bond Insurance Association or the American Municipal Bond Assurance Corporation, two major bond insurance companies. To receive insurance from either of these groups, the municipality must take out a policy and pay a premium.
FEDERAL GOVERNMENT AND FEDERAL AGENCY BONDS
This section describes forms and classes of bonds issued by the U.S. Treasury or by federal government agencies.
Government bond. A bond sold by the U.S. Government. Government bonds are rated the highest of all bonds. They are used to finance federal projects.
Treasury bond (T-bond). A bond issued by the U.S. Treasury to meet the government's financial needs. Treasury bonds are considered the safest bonds and are very popular with investors. They have maturities lasting from ten to thirty years.
Series EE bond. A bond that pays interest when it is redeemed. They are commonly known as savings bonds.
Series HH bond. A savings bond that pays interest and is sold at its face value. The denominations range from $500 to $10,000, and maturities last ten or twenty years.
Treasury note (T-note). An intermediate-term federal government debt, similar to a T-bond but maturing in one to ten years.
TIGRs, CATS and LIONs. These are types of zero coupon bonds. They stand for Treasury Investment Growth Receipts (TIGR), Certificates of Accrual on Treasury Securities (CATS), and Lehman Investment Opportunity Notes (LION). A different investment company offers each type. They are treasury bonds that sell at discount, do not pay interest and are redeemed for their face value at maturity. They were originals for their time in the early 1980's. Soon thereafter, copycat versions were issued from many other brokerages.
Agency bond. A bond issued by an agency of the federal government, such as the Student Loan Marketing Association (Sallie Mae). Government agencies are corporations, and the government does not guarantee agency bonds.
Mortgage-backed security (MBO). A government security that invests in a pool of mortgages. Many MBO's are bonds, but some are not. These bonds finance specific areas of the economy, such as housing or agricultural projects.
Collateralized mortgage obligation. A form of mortgage-backed security divided into sections, in which investors invest based on chosen maturities.
Finally, let's conclude with some additional terms related to bonds in "other" categories we may have missed.
OTHER BOND TERMS
The terms defined in this section cover subjects not discussed by the others. They also cover some of the subtler nuances of bonds.
Tax-exempt bond. A bond on which the holder is not required to pay certain kinds of taxes.
Variable-rate bond. A bond with a yield that changes over time, using a prescribed formula.
Zero-coupon bond. A bond sold at discount and paying no interest, but instead paying the holder the face value at maturity. A zero-coupon bond stated at $1000 but sold for $600 would yield the holder a total of $1000 at maturity. The extra $400 the investor makes would be treated as interest.
Series bonds. An set of bonds to be issued across different dates. They contrast with serial bonds, which mature across different dates.
Dow Jones Bond Average. An index composed of the average prices of six different bond groups. It is an indicator of the state of the bond market.
Income bond. A bond with a set interest rate, but the payment of which depends on the issuer's earnings.
This tutorial includes many, but not all, of the most commonly used bond terms and is intended as a general overview only. Before one makes and decision to invest, additional research should be conducted.
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