Fixed Income Concepts
Now that you know what fixed income securities are, here are some key terms to familiarize yourself with. The following concepts are important in valuing fixed income securities - is it worth your investment?
The coupon is the promised payment by the bond issuer to the bond holder (usually on a semi-annual basis) until the bond expires. The coupon is calculated with the coupon rate, which can be thought of as the interest rate and is expressed as an annual percentage of the bond’s face value.
Example: A corporate bond with a 4% coupon rate will pay $40 per $1000 of the bond’s face value, per year.
The bonds “expiration date” - the date on which the bond issuer owes the bond holder the principal amount (initial payment) and any final coupon payment.
Example: A bond with a 5% coupon rate, $1000 face value and 5 years to maturity. This means that the bondholder will receive a total of (5*2) 9 semi-annual payments and they will receive their 10th payment with their principal amount on the date of maturity. This is defined in the bond’s indenture before a deal is signed.
The two key values in bond pricing are the market price and the par value (aka face value). The market price is the current quoted price for the bond (the market value). On the other hand, the par value is the price at which the bond is issued and this is usually $1000. The principal payment received at maturity is the par value.
In practice, bond prices are quoted as a percentage of the par value. For example if the bond price is 100.00, then the bond is trading at the par value. If the bond price is 99.00, then the bond is trading at a discount to par value. If the bond price was 103.00, then the bond is trading at a premium to the par value.
- Market Price > Par Value : Premium
- Market Price = Par Value: Par
- Market Price < Par Value: Discount
Yield (Yield to Maturity)
The expected annual return on an investment and takes into account all the bond’s characteristics. A bond’s yield is inversely proportional to its price - so when the yield of a bond increases, its market price decreases and vice versa. For example: a bond with a 5% yield will be priced lower than a bond with a 4% yield.
You can compare the yield of a bond to its coupon rate to determine how the bond is trading, relative to its par value.
- Coupon Rate > YTM : Premium
- Coupon Rate = YTM : Par
- Coupon Rate < YTM : Discount
The possibility that the bond issuer might not be able to pay the bond holder the coupon payments or the final principal payment. This is known as default risk. To inform investors about the potential for default, a bond’s degree of risk is expressed through its credit rating. Companies like Standards and Poors and Moodys are in charge of rating bonds based on their creditworthiness. Bonds can be split into two categories; investment grade bonds and junk bonds. Investment grade bonds range from AAA to BBB- and junk bonds range from BB+ to D (for default). The bonds are rated on the capacity for the issuer to repay its bondholders.
This measures how sensitive a bond’s price is to changes in interest rates. Unlike time to maturity, the duration measure is non-linear and accelerates as the maturity date approaches. The higher a bond’s duration, the more sensitive the bond’s price is to changes in the interest rate, and the more the bond’s price will fall as interest rates rise.
With a longer maturity, a bond will have a greater duration because it is exposed to greater interest rate risk. On the other hand, the higher the bond’s coupon rate, the lesser the duration and interest rate risk.