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Bonds

Valuing Bonds

TermDefinition
Required Rate of Return The rate of return that investors expect or require an investment to earn given its risk.
Principal The amount borrowed on which interest is paid.
Maturity Date The date when a bond's life ends and the borrower must make the final interest payment and repay the principal.
Par Value (Bonds) The face value of a bond, which the borrower repays at maturity.
Coupon The periodic interest payment that a bond pays to investors.
Indenture A legal contract, between the borrower (issuer) and investor, stating the conditions under which a bond has been issued.
Coupon Rate The rate derived by dividing the bond's annual coupon payment by its par value.
Coupon Yield The amount obtained by dividing the bond's coupon by its current market price. (Also called the current yield)
Premium A bond trades at a premium when its market price exceeds its par value.
Yield to Maturity (YTM) The discount rate that equates the present value of the bond's cash flows to its market price.
Discount A bond trades at a discount when its market price is less than its par value.
Interest Rate Risk The risk resulting from changes in market interest rates causing fluctuations in a bond's price. Also, the risk of suffering losses as a result of unanticipated changes in market interest rates.
Real Return The inflation-adjusted return. Approximately equal to the difference between an investment's stated or nominal return and the inflation rate.
Nominal Return The stated return offered by an investment; includes the real return plus any additional return due to expected inflation.
Default Risk The risk that the bond issuer may not make all schedule payments.
Corporate Bonds Bonds issued by corporations.
Municipal Bonds Issued by U.S. state and local governments. Interest received on these bonds is exempt from federal income tax.
Treasury Bills Debt instruments issued by the federal government with maturities ranging from a few days to up to 52 weeks.
Treasury Notes Debt instruments issued by the federal government with maturities ranging from two to ten years.
Treasury Bonds Debt instruments issued by the federal government that mature in thirty years.
Agency Bonds Bonds issued by federal government agencies. Agency bonds are not explicitly backed by the full faith and credit of the U.S. government. Agencies issue bonds to provide credit for certain sectors of the economy such as farming, real estate, and education.
Floating-Rate Bonds Bonds that make coupon payments that vary through time. The coupon payments are usually tied to a benchmark market interest rate. Also called variable-rate bonds.
Prime Rate The rate of interest charged by large U.S. banks on loans to business borrowers with excellent credit records.
London Interbank Offered Rate (LIBOR) The interest rate that large banks charge each other for overnight loans. Widely used as a benchmark interest rate for short-term floating-rate debt.
Federal Funds Rate The interest rate that U.S. banks charge each other for overnight loans.
Spread The difference between the rate that a lender charges for a loan and the underlying benchmark interest rate. Also called the credit spread.
Treasury Inflation Protected Securities (TIPS) Notes and bonds issued by the federal government that make coupon payments that vary with the U.S. inflation rate.
Debenture An unsecured bond backed only by the general faith and credit of the borrowing company.
Subordinated Debenture An unsecured bond that has a legal claim inferior to, or subordinate to, other outstanding bonds.
Collateral The assets pledged to secure a loan.
Mortgage Bond A bond secured by real estate or buildings.
Collateral Trust Bond A bond secured by financial assets held by a trustee.
Equipment Trust Certificate A bond often secured by various types of transportation equipment.
Pure Discount Bond Bonds that pay no interest and sell below par value. Also called zero-coupon bond.
Treasury STRIPS A zero-coupon bond representing a single coupon payment, or the final principal payment, made by an existing Treasury note or bond. The acronym STRIPS stands for Separate Trading of Interest and Principal Securities.
Convertible Bond A bond that gives investors the option to convert it into the issuer's common stock.
Exchangeable Bond Bonds issued by corporations which may be converted into shares of a company other than the company that issued the bonds.
Callable (Bonds) Bonds that the issuer can repurchase from investors at a predetermined price known as the call price.
Call Price The price at which a bond issuer may call or repurchase an outstanding bond from investors.
Putable Bonds Bonds that investors can sell back to the issuer at a predetermined price under certain conditions.
Sinking Fund A provision in a bond indenture that requires the borrower to make regular payments to a third-party trustee for use in repurchasing outstanding bonds, gradually over time.
Protective Covenants Provision in a bond indenture that specify requirements the borrower must meet(postive covenants) or things the borrower must not do (negative covenants).
Yield Spread The difference in yield to maturity between a corporate bond and a Treasury bond at roughly the same maturity.
Basis Point 1/100 of 1%; 100 basis points equal 1.000%.
Bond Ratings Letter ratings assigned to bonds by specialized agencies that evaluate the capacity of bond issuers to repay their debts. Lower ratings signify higher default risk.
Junk Bonds Bonds rated below investment grade. Also known as high-yield bonds.
Term Structure of Interest Rates The relationship between time to maturity and yield to maturity for bonds of equal risk.
Yield Curve A graph that plots the relationship between time to maturity and yield to maturity for a group of equal-risk bonds.
Expectations Theory In equilibrium, investors should expect to earn the same return whether they invest in long-term Treasury bonds or a series of short-term Treasury bonds.
Liquidity Preference Theory States that the slope of the yield curve is influenced not only by expected interest rate changes, but also by the liquidity premium that investors require on long-term bonds.
Preferred Habitat Theory A theory that recognizes that the shape of the yield curve my be influenced by investors who prefer to purchase bonds having a particular maturity; also called market segmentation theory.
Created by: bj1white