Financial Terms for Bonds

Basic 101 Bond Market Terminology

March 1, 2012

Bonds vs. Equities

Bonds and equities are both financial instruments used by investors, but they have key differences:

Feature	Bonds	Equities
Ownership	Debt instrument (loan to issuer)	Ownership stake in a company
Return	Fixed interest (coupon) payments	Dividends + capital appreciation
Risk	Lower than equities	Higher, last in liquidation priority
Maturity	Has a fixed maturity date	No maturity date; held indefinitely
Volatility	Lower	Higher

Bonds are debt securities issued by corporations or governments to raise capital. Investors receive periodic interest payments (coupons) and principal repayment at maturity. Stocks, in contrast, represent ownership and potential profit-sharing through dividends and capital gains.

Bond Pricing and Yield Mechanics

Bond prices are influenced by:

Interest rates: Inversely related to bond prices. When rates rise, bond prices fall and vice versa.
Credit risk: Higher risk leads to higher required yields.
Time to maturity: Longer-term bonds are more sensitive to interest rate changes.

Key terms:

Face Value (Par Value): The amount repaid at maturity.
Coupon Rate: The interest rate paid annually or semiannually.
Yield to Maturity (YTM): The total return expected if the bond is held to maturity.
Duration: A measure of interest rate sensitivity.
Discount Rate: The rate used to calculate the present value of future cash flows. It reflects the required return an investor demands, which may be based on market interest rates, credit risk, and inflation expectations.

Bond pricing follows the formula:

\text{Price of Bond} = \sum \frac{C}{(1+r)^t} + \frac{F}{(1+r)^T}

$C$ = Coupon payment
$r$ = Discount rate - the rate used to calculate the present value of future cash flows. It reflects the required return an investor demands, which may be based on market interest rates, credit risk, and inflation expectations
$F$ = Face value (or Par Value) - the amount repaid at maturity
$t$ = The specific time period for each coupon payment
$T$ = The total number of periods until the bond reaches maturity

Example Pricing Ford Bond

A good example of a bond that carries higher risk but is not classified as a junk bond is the Ford Motor Company 10-Year Corporate Bond with a BBB rating by S&P.

Issuer: Ford Motor Company
Credit Rating: BBB (investment grade, but lower tier)
Face Value $(F)$ : $1,000
Coupon Rate: 6.5% (giving us $65 from $1000)
Annual Coupon Payment $(C)$ : $65
Maturity: 10 years
Yield to Maturity: 7.2% (reflecting its higher risk compared to government bonds)
Estimated Bond Price: $951.29 (calculated using the bond pricing model)

The estimated bond price of $951.29 is derived by discounting all future cash flows (coupon payments and face value) at the 7.2% yield to maturity. Despite the risk, this bond remains investment-grade, meaning it does not fall into the speculative (junk bond) category. Investors buy such bonds for higher returns while still maintaining a reasonable level of credit quality.

\text{Price of Bond} = \sum \frac{65}{(1+0.072)^t} + \frac{1,000}{(1+0.072)^10}

Expanding the coupon payments, paid annually and discounted:

\text{Price of Bond} = \frac{65}{1.072} + \frac{65}{1.072^2} + \frac{65}{1.072^3} + \text{...} + \frac{65}{1.072^9} + \frac{65}{1.072^{10}} + \frac{1,000}{1.072^{10}}

Adding that up, we get the following

\text{Price of Bond} = \frac{65}{1.072} + \frac{65}{1.149} + \frac{65}{1.232} + \text{...} + \frac{65}{1.870} + \frac{65}{2.004} + \frac{1000}{2.004}

This gives us our total:

\text{Price of Bond} = {452.342} + {498.944} = {951.29}

Corporate vs. Government Bonds

Feature	Corporate Bonds	Government Bonds (Gilts, Treasuries)
Issuer	Corporations	National governments (U.S. Treasuries, U.K. Gilts)
Risk	Higher (subject to default risk)	Lower (backed by government credit)
Yield	Higher due to credit risk	Lower due to perceived safety
Tax	Fully taxable	Some are tax-exempt (e.g., U.S. municipal bonds)
Liquidity	Lower than government bonds	Highly liquid (especially Treasuries)

Gilt vs. Treasury

Gilt: A bond issued by the U.K. government. Gilts are considered low-risk investments, similar to U.S. Treasuries, and are used to fund government spending.

Treasury (T-Bond, T-Note, T-Bill): A bond issued by the U.S. government. Treasury securities come in various maturities:

T-Bills: Short-term (less than 1 year), sold at a discount.
T-Notes: Medium-term (2-10 years), with semiannual interest payments.
T-Bonds: Long-term (10+ years), also with semiannual interest payments.

Bond Derivatives

Several derivative instruments exist in the bond market:

Interest Rate Swaps: Contracts to exchange fixed-rate payments for floating-rate payments.
Bond Futures: Standardized contracts to buy/sell bonds at a future date.
Credit Default Swaps (CDS): Insurance-like contracts that transfer credit risk of a bond.
Options on Bonds: Contracts giving the right, but not obligation, to buy/sell bonds at a specific price.
Interest Rate Options (Caps, Floors, Collars): Used to hedge interest rate risk.

Originally posted: March 1, 2012

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