The fixed income market in many respects has its own language, and as such we provided a summary of many of the key terms that one will encounter in any fixed income discussion. For your interest(!):
- Accrued Interest — Interest on a debt security that accumulates during the period between coupon payment dates but has not yet been paid. When the security is sold on a date other than a coupon payment date, the buyer must pay the accrued interest to the seller.
- Basis point — One one-hundredth of a percent. For example, 1% = 100 basis points.
- Benchmark Rates — Widely-recognized, short-term interest rates used as the basis for determining coupon rate paid on floating- (adjustable) rate loans, mortgages, and other types of debt. Most common in the U.S. market:
SOFR – Secured Overnight Financing Rate. This rate reflects the cost of overnight cash borrowings cash that are collateralized by Treasury securities
LIBOR – London Interbank Offered Rate. The cost of borrowing U.S. dollars in the London interbank market for terms ranging from one to 12 months. Formerly the most widely-used benchmark rate, LIBOR quotes were found to be compromised and it has been all but replaced by SOFR.
Prime Rate – The benchmark interest rate banks charge to their most creditworthy (“prime”) borrowers; others pay a higher rate (Prime plus X%).
Fed Funds – The interest rate at which commercial banks can lend excess reserves held at the Federal Reserve to other banks that need to borrow them overnight. The Fed Funds rate target is used by the Fed to control short-term interest rates.
- Bond Type – Major categories of bonds, based on the issuer (and thus the ultimate source of repayment for the investor). Includes U.S. Treasury, Government Agency, Corporate (often separated into Investment Grade and High Yield), Supranational, Non-U.S. Sovereign, Municipal, and Securitized bonds.
- Call feature – Allows the issuer to buy back a bond issue prior to its maturity date by paying investors a price equal to or above the face value of the bond (depending on the specific terms), on or after a certain date. Issuers may choose to exercise this “call option” if coupon rates on new bonds are below the rate it is paying on the bond to be called.
- Call schedule – A series of dates prior to the Maturity Date when a bond issuer is allowed to call a bond, at a price that is usually above par. The call prices corresponding to each date in the schedule usually decline over time, as the bond approaches maturity.
- Call type: Discrete vs. Continuous – Determines whether the call schedule allow a bond to be called by the issuer only on a specific date, which is usually a coupon pay date (discrete), or any date thereafter (continuous).
- Convertible bond – Corporate bonds that give the investor the right (but not the obligation) to exchange the bond for a preset number of shares of the issuer’s common stock. This upside potential usually reduces the coupon rate below what the issuer would have to pay to raise funds via a non-convertible bond issue.
- Convexity (option-adjusted) – The incremental percentage change in a bond’s price that duration (which is a linear approximation of the relationship between changes in bond prices and yields) misses.
Usually positive, but often negative for callable bonds and those with other types of embedded options. For option-free bonds, convexity is the second derivative of a bond’s price with respect to a change in its yield.
- Coupon frequency – The number of times per year coupon payments are made on a bond. In the U.S., Treasuries, Agencies, Corporate bonds, and Municipal bonds almost always pay coupons semi-annually.
- Coupon rate – The interest rate paid on a bond, expressed as an annual percentage.
- Coupon type – Determines whether the coupon rate on a security will remain unchanged (fixed) or will change from time to time prior to maturity:
Fixed – Coupon rate is fixed for the life of the bond. Determined by the interest rate environment and the borrower’s perceived creditworthiness when the bond is issued.
Floating (also “adjustable” or “variable”) – Coupon rate changes periodically according to a formula based on a benchmark rate plus a spread to account for credit risk, set at the time the bond is issued. Often has a maximum (cap) and minimum (floor).
Step-up/Step-down – Coupon rate is fixed for a number of years but steps down or up to a new rate on a future date (usually a call date) if certain conditions are or are not met.
- Credit Rating Agencies – Independent firms that assign ratings to debt instruments based on their view of the likelihood the issuer will pay interest and principal when due. Ranging from highest quality (lowest likelihood of default) to lowest (usually in default), the most widely used rating agencies’ rating hierarchies are as follows:
- Day-count – Determines the number of days used to calculate accrued interest on a given date between coupon payment dates. The numerator is the total number of days that could accrue in a given month, and the denominator is the number of days in the entire accrual period. U.S. Treasury securities accrue interest using an Actual/Actual day-count, corporate and municipal bonds use a 30/360 day-count, and money market instruments typically use an Actual/360 day-count.
- Default – Occurs when a borrower fails to make interest or principal payments when due. A default on one debt instrument typically triggers a default on all of the borrower’s debt. A “technical default” occurs when the borrower has not missed a payment but fails to uphold one or more loan covenants.
- Discount or premium – A bond priced below 100 is trading at a discount; a bond priced above 100 is trading at a premium (see Price). The discount or premium depends on whether interest rates and/or perceived credit risk make a bond’s coupon rate less attractive (discount) or more appealing (premium) relative to coupons on new, similar bonds.
- Duration – Broadly speaking, the sensitivity of a bond’s price to a change in interest rates. In general, the longer the time to maturity, the higher the bond’s duration. Referred to as duration “years”, although that can be misleading. Three types of duration are commonly used:
Modified (Macaulay) – The first derivative of a bond’s price with respect to a change in its yield-to-maturity. Equals the weighted average years until all future payments (in present value terms, as a percentage of the bond’s price) are received. “Modified” refers to a small adjustment made for yield-to-maturity’s semi-annual compounding.
t = the number of years until a cash flow (coupon + any partial principal repayment) is received,
C = the cash flow received at time t,
n = the number of years until the final maturity date (when the last cash flow is received),
M = the final cash flow received in year n,
Y = the bond’s yield
f = the frequency of compounding used to compute y (semi-annual in the U.S.)
Option-adjusted Duration – The percentage change in a bond’s price based on a shift in the entire Treasury yield curve. Requires re-pricing the bond under higher/lower interest rate environments to capture the effect of call options, coupon resets, or other factors that would cause a change in rates to affect the amount and/or timing of the bond’s cash flows.
Duration-to-worst –Modified duration computed using interest and principal payments to the bond’s maturity date or to a date when the bond could be called by the issuer, whichever would result in a lower return to the bondholder.
- Face value – The principal amount of a debt security that is owed to the owner of that security (the investor) on the Maturity Date. In the U.S., the face value of bonds is $1,000.
- Floating rate coupon – See Coupon Rate, Floating
- Issuer – The entity responsible for making interest payments and repaying principal for a debt instrument, when due. With corporate bonds, the issuer may be a subsidiary of a parent company; in this case the bondholder relies on that subsidiary’s ability to pay.
- Make-whole call – Allows an issuer to retire a bond early by paying investors a price based on the yield-to-maturity of a maturity-matched Treasury plus a credit spread. Thus (unlike a regular call feature), the investor earns a “market return” and is made whole.
- Maturity date – The date on which a bond stops accruing interest and the issuer must repay the remaining principal owed. The remaining time to maturity is an important consideration for investors as it has a large impact on a bond’s duration (sensitivity to interest rate shifts).
- Next reset date – For securities with floating (adjustable) coupons, the date when the new coupon rate for the next accrual period will be computed from the coupon formula.
- Next reset rate – For securities with floating (adjustable) coupons, the coupon rate to be used during the next accrual period, computed from the coupon formula. Determined in advance as the coupon formula uses a benchmark index value prior to the reset date.
- Par value – Used interchangeably with face value, refers to a bond’s nominal value, i.e., the amount on which interest payments are based, and that must be repaid at maturity.
- Price – Bond prices are quoted as a percent of Par. For example, a bond trading at its face value of $1,000 is priced at 100; a bond currently worth $990 is priced at 99. Bond prices do not include accrued interest (the price is “clean”); to determine a yield-to-maturity from a price, the accrued interest must be added to the dollar amount the price represents.
Ask price – The price at which a seller (usually a broker-dealer) is willing to sell a bond to a buyer (usually an investor).
Bid price – The price at which a buyer (usually a broker-dealer) is willing to buy a bond from the seller, which is lower than the “ask” price.
The difference between the bid price and the ask price is a spread the broker-dealer earns for facilitating trades. The more liquid the security, the tighter the spread.
- Preferred stock – A hybrid of a stock and a bond, “preferreds” pay a dividend (typically quarterly, like a stock), but have a par value and a maturity date. Some are “perpetual”, so they have no stated maturity, but are callable, usually any time starting five years after the issue date. Bonds are senior to preferred stock in the event of a bankruptcy.
- Puttable bond – Gives investors the right to force an issuer to buy a bond back at par on a specific date. This is valuable if interest rates are higher than when the bond was issued, or the issuer’s credit quality has deteriorated. In practice, puttable bonds are rare.
- Sector – Bond market sectors are defined by the type of issuer that stands behind the promise to pay interest and principal on a security. The main sectors are:
Treasuries – issued by the sovereign entity of the country of issuance.
Agencies – issued by a government agency. Examples include the Federal Home Loan Bank and the Small Business Administration. May not be government guaranteed.
Corporates – subdivided into Industrial, Financial, and Utility issuers, largely because they tend to be impacted differently in economic downturns.
Supranationals – issued by organizations with members from more than one country who work together to pursue economic and social objectives. Examples include the World Bank, African Development Bank, Asian Development Bank, and others.
Sovereigns – issued by a sovereign entity of another country. Smaller countries often issue sovereign debt in other countries to tap into a larger investor base than their home country. Includes both developed and emerging market issuers.
Securitized – includes Asset-backed Securities (ABS), Mortgage-backed Securities (MBS), and Commercial Mortgage-backed Securities (CMBS). Payments come from cash flow from the collateral, which are loans. The “issuer” is a trust that owns the collateral.
Municipals – issued by state and local governments to pay for a wide range of projects. Payments on some “muni” bonds come from specific revenue sources, such as toll road fees; others rely on taxes levied on residents and businesses in the state, county or city.
30. Spread –The difference between the yields of two securities, where one is typically (but not always) a risk-free benchmark such as a Treasury. The spread reflects differences in risks, such as credit risk and liquidity risk. Often used to specify a yield, and therefore a price – e.g., if a spread is quoted as 1.25% and the matched Treasury yield is 3.00%, the yield on the bond being priced is 4.25%, which can then be used to compute a price.
Spread to Treasury – The yield-to-maturity of a fixed coupon debt security (or the yield-to-worst on a callable bond) minus the yield-to-maturity for a Treasury with a similar time to maturity, interpolated from the Treasury yield curve. Also called the nominal spread or G-spread.
Option–adjusted Spread – A spread used to price, or assess the risk premium of a security with embedded options (such as a callable bond or mortgage-backed security). The OAS reflects the uncertainty of the timing and amount of a bond’s future cash flows due to the presence of options. Given this uncertainty, instead of determining a spread from the yield of a single maturity-matched Treasury, OAS considers how interest rates in the future are likely to affect the bond’s cash flows using the entire Treasury curve. The OAS matches the present value of possible future cash flows to the bond’s current price.
- STRIPS – Created from Treasury securities. Wall Street firms “strip” the coupons (interest payments) and the principal from a Treasury security and sell the individual future payments as separate securities. A 10-year Treasury would be turned into 21 zero-coupon STRIPS (20 from the interest payments, one from the principal), maturing every six months for the next 10 years. Stands for Separate Trading of Registered Interest and Principal of S
- T-Bills – Securities issued by the U.S. Treasury with maturities up to one year; often used as an ultra-safe place to invest cash for the short-term. T-bills pay no interest but are issued at a discount to their face value; the yield is determined by the difference between the price and the face value. The most common maturities are four, eight, 13, 26, and 52 weeks.
- TIPS – Stands for Treasury Inflation Protected S TIPS pay a fixed coupon rate but the face (par) amount increases over time, based on the All-Urban Consumer Price Index (CPI-U). As the par value rises, the dollar amount of interest paid increases. Issued with maturities of 5, 10, and 30 years.
- Treasury Bonds and Notes – Issued by the U.S. Treasury in maturities ranging from two to thirty years, to help fund the government’s activities and refinance maturing obligations. Almost all have fixed rate coupons. The most recently issued Treasuries of each maturity are known as “on-the-run” issues whose yields are often used as benchmarks. Technically, only issues with original maturities longer than 10 years are “Bonds”; the others are “Notes”.
- Treasury Auctions – Treasury securities are issued via regular auctions to determine the initial price, and thus the initial yield and coupon rate for an issue. Using open, competitive bidding helps to minimize the government’s borrowing costs. Generally speaking, after the close of bidding the Treasury accepts bids in order of increasing yield, until it reaches the specified amount of the offering. The highest yield that must be accepted to fill the offering determines the price for all auction participants. The coupon rate is set at the highest level (in increments of 1/8th of a percent) that does not result in a price above 100 (see Price).
- Yield – The rate of return an investor will earn by paying a specific price for a debt security, assuming interest and principal payments are made on time (i.e., no default). Bond yields changes to reflect current demand for bonds of a given maturity, coupon rate, and credit quality. A number of different “flavors” of yield may be quoted for a bond:
Yield-to-maturity – The internal rate of return (IRR) that makes the sum of the present values of a bond’s future cash flows (interest payments plus the par value repaid at maturity) equal to the current price of the bond. For callable bonds, this assumes the bond will not be called.
Yield-to-call – Assumes the bond will be called on the first possible Call Date. Therefore, this is the internal rate of return (IRR) that makes the sum of the present values of a bond’s future cash flows (interest payments only up to the next Call Date, plus the par value and any premium owed for calling the bond, paid on the Call Date), equal to the current price of the bond.
Yield-to-worst – The lower of the Yield-to-Maturity and the Yield-to-Call, this is typically the yield used for a callable bond. It is a conservative (worst-case) view of the return the bond will offer based on the current price, as the issuer will only call a bond when it is economically advantageous to the issuer, and therefore disadvantageous to the investor.
Current yield – The bond’s coupon rate divided by its current price. If the price is above par, the current yield will be lower than the coupon rate, and vice versa. Similar in spirit to a dividend yield on a stock, but a bond’s price will eventually move toward 100 (par).
- Yield Curve – The graph of the yields on bond from a given issuer that correspond to a range of maturity dates. Most of the time, this term refers to the Treasury yield curve, constructed from yields on Treasury securities ranging from 3 months to 30 years, although yield curves can be created for other markets, e.g., from corporate bonds of a particular credit quality.
Normal vs Inverted – Most of the time, the yields on Treasury securities increase as the time to maturity increases (e.g., the yield on a 2-year bond is lower than the yield on a 3-year bond, which is lower than the yield on a 5-year bond, and so on). Graphing these yields creates an upward-sloping curve, which is referred to as a “normal” curve.
Sometimes, the yields on longer-maturity Treasuries are lower than the yields on shorter-maturity Treasuries. This “inverted” yield curve shape indicates that investors expect the economy to slow, and possibly enter into a recession.
- Zero-coupon bond –A bond that pays no interest and thus always trades at a price below par. The yield-to-maturity on a 0% bond is the discount rate that sets the present value of the principal paid at maturity to the current price of the bond. A zero-coupon bond has the longest duration (highest interest rate sensitivity) of all bonds of a given maturity.
Additional Municipal Bond Terms
- AMT bonds – Interest income from most municipal bonds is exempt from federal taxes, and in some cases from state taxes also. However, interest from some munis (mostly bonds issued to help fund private activities that have some public benefit, such as a sports arena) is included when determining a taxpayer’s Alternative Minimum Tax.
- De Minimis rule – When a municipal bond is purchased at a discount to par, over time the amount of the discount is taxed as ordinary income for an investor because the bond will eventually mature and pay the investor its full face value. However, if the amount of the discount is small (i.e., “de minimis”) it is taxed as a capital gain. If the discount is less than 0.25% of the bond’s face value of a bond for each year from the date of purchase to maturity, it is considered “de minimis”. As yields rise, more munis trade at a discount and can “fail” the de minimis
- Muni bond types – The municipal bond market is segmented into four broad categories based on the primary sources of repayment for these bonds.
General Obligation – Backed by the taxing authority of the issuer. Generally viewed as a positive in terms of a bond’s creditworthiness, except in states with a weak tax base and chronic budget shortfalls.
Insured – These bonds are backed by third-party insurance that guarantees payment of interest and principal if the issuer is unable to meet those obligations. Issuers pay for insurance to make their bonds more appealing to investors, which reduces the coupon rate the issuer would have to pay to attract investors if the bond was not insured.
Pre–refunded – A muni bond that has not yet reached its first call date but is guaranteed to be called on that date. Issuers can buy and set aside (escrow) U.S. Treasuries or other high-quality issues in amounts sufficient to cover interest payments and pay the call price for a bond it wishes to call. This means the bond will definitely be called, so its maturity date is now the call date, and the credit quality of the bond is equivalent to the rating on the securities that are backing them.
Revenue – A municipal bond whose interest and principal are paid from revenues derived from a specific source, such as water, sewer, and electric utilities and highway tolls. The credit quality of these bonds depends on the reliability of these revenue streams.
- Muni sectors – Revenue bonds are divided into sectors based on the source of repayment for the bonds, such as Airports, Health Care, Education, Toll Roads, Utilities, and others. These sectors have varying degrees of sensitivity to economic downturns, which could affect the reliability of the cash flows needed to support the bonds.
- Original Issue Discount (OID) – A municipal bond issued at a discount to par has a below-market coupon rate. The discount essentially compensates investors for the low coupon and is considered to be part of the income investors receive from the bond. Therefore, the amount of the OID is usually exempt from ordinary income and capital gains taxes.
- Taxable-Equivalent Yield –A way of comparing the yield offered by a municipal bond that offers tax-free interest income to the yield on a corporate bond or other non-municipal security whose interest payments are taxable. For example, to compare a municipal bond that offers a 3.5% yield with corporate bonds of a similar duration and credit rating) a taxpayer in a 25% marginal tax bracket would compute the “taxable-equivalent” as follows: 3.5% ÷ (100-tax rate of 25%) = 4.67%. Therefore, the municipal bond’s yield is equivalent to a corporate bond yielding 4.67%, as the investor would keep only 75% of the income from the corporate bond after taxes.
Additional Sources of Fixed Income Information:
- Treasuries https://fred.stlouisfed.org/tags/series?t=corporate%3Bu.s.%20treasury&rt=corporate&ob=pv&od=desc
- Corporates https://www.finra.org/finra-data/fixed-income/corp-and-agency/trade; also https://fred.stlouisfed.org/tags/series?t=corporate%3Bu.s.%20treasury&rt=u.s.%20treasury&ob=pv&od=desc
- Munis https://emma.msrb.org