Bond Market Terminology

 

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Coupon rate and Coupon:
It is the rate at which issuer pays to the investor. The amount of interest that is being paid out periodically is called coupon. The frequency of coupon payment is predetermined. The coupon is, usually, paid out semi annually for long term bonds.

Maturity:
Maturity is the date on which the issuer has agreed to pay the last installment of the borrowed amount. The cash flows to the investor ends at this date i.e. the agreement expiry date.

Tenor:
The number of years remaining for the bond to mature is called tenor or term to maturity. It gives information of time over which the investor will continue to receive the coupons. The price of the bond is influenced by term to maturity.

Principal:
Principal is the amount that the issuer agrees to repay at the end of maturity. This is called as par value or face value of the bond.

Yield:
Yield of bond is return on investment. The return from a bond can come from the following

Coupons received.
Return on coupons. The coupons received can be reinvested and get returns. Capital gains. Capital gain/loss is the difference between the sell price and the buy price. If a bond with a par value Rs 1000 is bought at Rs1050, at the redemption it is worth only Rs1000 giving capital loss of Rs50. If a bond is bought at a discount of Rs50 on par value i.e. Rs950, at the time of redemption it gives Rs 1000 with a capital gain of Rs50.

Current Yield:
Current yield is defined as the ratio of annual coupon to market price of a bond. If a 12% bond’s value in the market is Rs 108, then current yield is 12/108 = 11.11%
Current yield doesn’t consider the future cash flows, reinvestment income and capital gain or loss. So it’s not used as standard measure of return on investment.

Yield to Maturity (YTM):
Yield to maturity is the returns that would have been received on investment if the bond were held till the maturity. It is the discounting rate that would equate present value of all cash flows to the price of the bond.

Let us understand the concept of yield to maturity with a simple example.

Consider a bond is bought at Rs 1100 whose par value is Rs1000, coupon rate is 12 %, tenor is 10 years and the frequency of coupon payment is semi annual. Now equate the discounted future cash flows to the price of the bond

6/ (1+r) + 6/ (1+r) 2 + 6/ (1+r) 3 + …………….+ 1006/(1+r) 20 = 1100

Solving the above equation you will get the r value. This r value is semi annual return. So the yield to maturity for this bond is 2r. This method assumes that the coupons received would be reinvested at the discounted rate 2r or YTM. This assumption is not true because market interest rate on similar instruments keep on changing so the actual interest rate of reinvestment of coupons would be different from YTM.

Realized Yield:
YTM assumes that bond is held till maturity, so the actual rate of return is not equal to YTM if the bond is sold before maturity. The actual rate of return till the time of sale of a bond considering the actual interest rate for coupon reinvestment is called realized yield.

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May 25, 2008 | Filed Under Bonds 

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