Some technical terms for bonds
• Yield is the return achieved from the bond. There is a whole host of different yields. The two main ones are:
• Current yield (also called interest yield, flat yield, income yield, simple yield, annual yield or running yield) is the annual income received divided by price of the instrument.
In our earlier example with a bond offering a £5 annual coupon and selling in the secondary market for £97.327, the current yield is £5 ÷ £97.327 = 5.137%.• Yield to maturity (also called redemption yield or gross redemption yield) is the most important and is the one quoted in bond charts and tables. It is the annual rate of return offered on the bond taking into account all remaining coupon payments and the capital gain or loss on the bond between its current price and the redemption face value. For our example bond offering £5 per year and a capital gain over three years of £100 minus £97.327 the yield to maturity is 6%. An explanation of yields and the calculations is in Chapters 12 and 13.
• Put option can be added to the bond holder's set of rights in the initial agreement. It gives the holder the right but not the obligation to demand that the issuer redeems the bond before its normal maturity date, i.e. to sell it back to the issuer at a price that was fixed when the bond was first issued. If interest rates have risen, resulting in the bond price falling, an investor might seek to sell the bond to the issuer at the agreed price. The mere existence of the right to receive full payment for the bond without recourse to selling in the secondary market generally ensures that the price remains above par value. This extra advantage for the holder has to be paid for - usually achieved by the issuer offering a lower yield in the first place.
• Call option (callable bond) gives the bond issuer the right but not the obligation to repurchase the bonds from the holder at a defined price; the issuer can insist that the bond holder sell at a price at certain dates during the life of the bond.
Issuers may exercise this option if they no longer need the funding or if they think they could reissue replacement bonds at a more favourable yield rate (this may happen if market interest rates for this risk class and time to maturity have fallen since the bond was first issued, i.e. the bond price has risen). They are also aware that some bonds place tight covenant restrictions on the firm so it is useful to be able to buy them back and issue less restrictive bonds in their place. Finally, exercising the call may permit the firm to adjust its financial leverage (that is the amount of debt relative to shareholders' equity capital) by reducing its debt. For these call privileges the issuer will pay a higher coupon rate from the outset. In other words, the bond will be sold for less than it would without the call feature (and this also applies to secondary market prices). The fact that the bonds can be called back for redemption at any time is obviously not something bond holders favour without offsetting compensation, especially when the bond price would otherwise have risen significantly above the par value.• Usually bonds are set up with a bullet structure, where regular payments made reflect the interest only and the whole of the principal amount (face value) is repaid at maturity. Balloon interest means that the coupons paid on a long-term bond rise over time. Thus bonds issued to finance the construction of a wind turbine field might pay low coupons in the early years when income is poor and expenses high, but then, after the first three years, the coupons grow larger.
• Principal is the amount that will be repaid on maturity, typically £100, £1,000 or $1,000. It has various names: face value, par value, face amount, redemption value or maturity value.
• Coupon rate is the amount of interest paid per year expressed as a percentage of the principal. Typically it is paid twice a year, or semi-annually, but it could be paid more or less frequently than this.
It is also known as interest rate, dividend or nominal rate.• Zero coupon is when a bond does not pay interest/coupon payments, but is redeemed for face value at maturity. The return that an investor receives on these bonds is achieved by buying the bonds at a discounted price which is less than face value. So a five-year zero coupon bond that will be redeemed at £100 might be selling at £60 today. Using the discounted purchase price and the time to redemption, it is possible to work out the annual yield during the life of the bond, which in this case works out at 10.76% (see Chapter 13 for the calculations).
• Convertible bonds can be converted at the insistence of the holder into shares or other securities of the issuing company, usually equity shares.
• Floating-rate notes (FRNs) (also called variable-rate notes) have a variable coupon reset on a regular basis, usually every three or six months, in relation to a benchmark or reference rate. The typical term for an FRN is about 5-12 years.
• Bond funds are collective investment vehicles which enable small/retail investors as well as major financial institutions to invest in a broad portfolio of bonds. Some are listed on stock markets, others are traded over the counter in tailor-made deals.