Both stocks and bonds have their own unique terminology. Here are a few pieces of bond terminology that you may find useful when embarking upon your bond investing strategy:
Maturity is when the bond comes due, the date when the principal or par amount of the bond is paid to investors and the company’s bond obligation ends. Maturity is an important factor when analyzing whether a bond will fit into your investing strategy. Maturity can be further broken down:
- Short-term: Maturity within one to five years
- Medium-term: Maturity within five to 10 years
- Long-term: Maturity 10 - 30 years
Secured/Unsecured. A secured bond pledges collateral to bondholders in case the company cannot repay its obligation. If the bond issuer defaults, the investor receives the collateral. An example is a mortgage-backed security (MBS) that is backed by titles to the homes of the borrowers.
Alternatively, unsecured bonds are not backed by collateral. These bonds are also called debentures, and the risk is greater than secured bonds.
Liquidation Preference is the order in which a firm pays its investors should it go bankrupt. Holders of senior debt are paid first, followed by junior (subordinated) debt. Stockholders get whatever is left.
Coupon is the interest paid to bondholders, normally annually or semiannually. The coupon is also called the coupon rate or nominal yield. It can be calculated by dividing the annual payments by the face value of the bond.
Tax Status, either taxable or tax-exempt.
Callability means the issuer of a bond can “call” it, or pay it off before maturity, usually at a premium to par or face value. This might happen if rates decline after a bond is issued so that the company could reissue it at a lower rate, thereby saving interest paid. Callable bonds usually offer higher coupon rates to make them more attractive to investors.
Bond Risk is a factor to consider before investing. Here are a few related bits of bond terminology that help explain unique risks you can expect when purchasing bonds:
Interest Rate Risk is the risk that rates could undergo significant changes. If they decline, prepayment of the bonds may occur and the investor’s expected cash flow declines. Or if rates rise, your bond may yield below market interest, so its price will decline as newer, higher-rate bonds come on the market. It’s important to note that the longer time period before your bond’s maturity, the greater the interest rate risk will be, as there will likely be many periods of interest rate changes through the years.
Credit/Default Risk is the risk that interest and principal payments will not be made as promised by the bond issuer. And that’s where bond ratings become very important (Moody’s, Fitch, and Standard & Poor’s are the three main evaluators, this page from Fidelity compares their rating side by side).
Prepayment Risk arises if/when a bond is paid off earlier than expected, normally through a call provision.
Bond Yields are simply the measures of return, and include:
Yield to Maturity (YTM), most often used, measures what the return on a bond is if it is held to maturity and all coupons are reinvested at the YTM rate (for bond funds).
Current Yield is calculated by dividing the bond’s annual coupon by the bond’s current price. It is used to compare the interest income provided by a bond to the dividend income provided by a stock. Of course, this calculation says nothing about principal; it is only related to cash flow.
Nominal Yield is calculated by dividing the annual coupon payment by the par or face value of the bond. It equals the percentage of interest to be paid on the bond periodically.
Yield to Call (YTC) is used to calculate the yield if the bond is called at a particular call date, when it will most likely receive a higher premium. Investors want to know this so they can decide if the prepayment risk is worth a shot.
Realized Yield is the yield of a bond if an investor plans to hold a bond only for a certain period of time, instead of to maturity. This calculation involves an estimate of the future price the bond can be sold at so you can forecast an estimated return.
A few of these calculations are complex, but fortunately, your broker—or an Excel spreadsheet—can assist you.
These are just a handful of terms that you’ll encounter when you’re investing in bonds that you may not have come across when investing in stocks and ETFs.
And, while we’re stock pickers at heart, having a portion of your portfolio allocated to fixed income can help add ballast and stabilize your returns from year to year.
*This post has been partially excerpted from Cabot Money Club Magazine, to read more Money Club content join Cabot Money Club today!