Bonds are a notoriously hard asset class to understand when you scratch beneath the surface. It doesn’t help that the bond world speaks in its own unfamiliar language – one festooned with special bond terms that are hard to learn if you’re an outsider.
Our remedy is this quick guide to the main bond jargon you need to know. We’ll add more over time, to make this jargon buster a companion to our bond articles [1].
Bond terms to know
Bond market interest rates
‘Interest rates’ in the context of bonds does not refer to the central bank interest rates we’re used to. Instead, we’re talking about the rates that prevail within the bond market.
Each and every bond is subject to a ‘market’ interest rate – which is the return investors demand for locking up their money in that particular bond at that time.
Investors express their demand through their decisions to buy and sell.
Market rates fluctuate in-line with economic data. Changes to inflation expectations, a bond’s credit rating, its maturity date, and yes, central bank interest rates – all this and more feeds into market interest rates.
Principal
A bond’s principal is the original value of the loan made to the bond issuer. When the bond matures, the principal is paid back to whoever owns the bond on that date.
Principal is also called par value, nominal value, or face value. The standard face value of a UK gilt is £100.
Coupon rate
The fixed interest rate paid by a bond. For example, a bond with a 4% coupon pays £4 per year on its principal of £100.
Maturity date
The day the bond debt is finally cleared. On that day the issuer pays the bondholder the face value of the bond. The parcel of debt it represents is cancelled out – the bond is redeemed.
Yield-to-maturity
Yield-to-maturity (YTM) is a bond’s expected annualised return if you hold it to maturity (ignoring costs). This yield takes into account the bond’s current price, and assumes all remaining coupon payments are reinvested at the same yield.
An individual bond’s yield-to-maturity continually adjusts to reflect market interest rates as investors trade.
The mechanism is:
- When a bond’s market interest rate rises, its price falls. (Investors require a greater incentive to hold this bond – hence prices drop.)
- When a bond’s market interest rate falls, its price rises. (Investors are more willing to hold this bond – hence they’ll pay more.)
- When a bond’s price falls, its yield-to-maturity rises. (The price fall causes the yield to increase to match the higher market interest rate).
- When a bond’s price rises, its yield-to-maturity falls. (The price rise causes the yield to decrease to match the lower market interest rate).
This piece helps explain what happens to bonds when interest rates rise [2] and fall.
YTM is the go-to metric to use when comparing similar bonds (for example gilts) that vary by price, maturity date, and coupon.
There are many types of bond yield [3]. But we’re usually talking about YTM when we use the term ‘yield’ in an article on Monevator.
Nominal / conventional bond
The standard type of bond that pays back a fixed coupon rate and a fixed face value. Nominal bonds contrast with index-linked bonds that make payments in line with inflation. Index-linked bonds are also called inflation-linked bonds, or ‘linkers’ if they’re gilts and TIPS if they’re the U.S. equivalent.
High-grade bond
A bond with a credit rating of AA- and above (or Aa3 in Moody’s system). Typically the highest-quality bonds are government bonds.
Credit rating
This is a guesstimate of the financial strength of the bond issuer. That means for example the UK and other governments for government bonds, or the issuing company for corporate bonds.
AAA is the top-notch rating. BBB- sets the floor for investment grade. Below that is termed ‘high-yield’ or less flatteringly ‘junk [4]’.
The higher the credit quality rating, the better. It means there’s less chance the issuer will default on payments, according to the bond rating agencies.
Of course you’ll usually have to accept a lower yield for a (less risky) higher credit rating.
Duration [5]
Modified duration is an approximate guide to how much a bond will gain or lose in response to a 1% change in its yield.
For example, if a bond or bond fund’s [6] duration number is 8, then it:
- Loses approximately 8% of its market value for every 1% rise in its yield
- Gains approximately 8% for every 1% fall in its yield
Macaulay duration is the average time (in years) it takes to receive all of your bond’s cash flows (coupons and principal). It also tells you how long it takes to recoup a bond’s price.
Macaulay duration in particular is a complicated concept [7] for non-financial wonks to wrap their heads around. But happily, you don’t really need to.
Duration as used to describe interest rate sensitivity is the more important of the bond terms here for everyday investors because it provides insight into how wildly your bond or fund’s price may change as rates fluctuate.
Macaulay duration becomes relevant if you practice duration matching – which we’ll cover in an upcoming two-parter.
Interest rate risk
Here the risk is that an adverse move in bond interest rates causes losses. This risk decomposes into two elements:
- Price risk
- Reinvestment risk
Price risk
Price risk materialises when bond interest rates rise and cause your bond’s price to drop, inflicting a capital loss.
Reinvestment risk
When market interest rates fall, bond yields fall. Reinvested cashflows now earn a lower yield which erodes your annualised return over time.
Other bond terms that confound YOU
Time for a bit of crowdsourcing! We know that many readers are confused by bonds, so is there any particular jargon you’d like to see included in this guide?
Let us know in the comments below and we’ll add it to the guide.