Bond Basics Part 4: Useful Charts and Definitions
A useful guide to the world of bonds...
Be sure to read the rest of the Bond Basics series:
Be Sure You Pay the Right Price
- Investors who want to check recent transaction prices in the municipal bond market can get daily price and yield information for thousands of actively traded municipal bonds on www.investinginbonds.com.
Effect of federal income taxes on yields of tax-exempt and taxable instruments
5% Tax-exempt bond 7% Taxable bond Cash Investment $30,000 $30,000 Interest $1,500 $2,100 Federal income tax bracket $0 $693 Net Return $1,500 $1,407 Yield on investment after taxes 5.00% 4.70%
Credit Risk Moody's Standard & Poor's Fitch Prime Aaa AAA AAA Excellent Aa AA AA Upper medium A A A Lower Medium Baa BBB BBB Speculative Ba BB BB Very Speculative B, Caa B, CCC, CC B, CCC, CC, C Default Ca, C D DDD, DD, D
10% 15% 25% 28% 33% 35% 36% Single Return $0-$7,300 $7,300-$29,700 $29,701-$71,950 $71,951-$150,150 $150,151-$326,450 $326,451 & over Sample effective marginal rate for certain Joint Return $0-$14,600 $14,601-$59,400 $59,401-$119,950 $119,951-$182,800 $182,801-$326,450 $326,451 & over High income tax payers
Tax-Exempt Yields and Their Taxable Yield Equivalents
Terms & Definitions
- Accrued Interest: The amount which the buyer of a fixed-income security must pay the seller of the security to compensate the seller for holding the security between the last coupon payment date and settlement date. The accrued interest, added to the instrument’s dollar price, constitutes the net amount, net proceeds or invoice amount. How this accrued interest is calculated varies from security to security. Depending on the type of bond, the accrued interest calculation uses one of several day count conventions for calculating the difference between two dates. The most common day count conventions are Actual/Actual, 30/360, and 30/360 European.
- Banker’s Acceptances: Banker’s acceptances (Bas) are short-term interest at maturity notes. These notes do not bear interest but are sold at a discount and redeemed for full face value by the accepting bank at maturity. Both the issuer and the accepting bank guarantee the BA.
- Bond Equivalent Yield: Discount securities, like Treasury bills, are quoted on a bank discount basis. But the discount basis is not a yield, and so cannot be compared to yield of other instruments. The bond equivalent yield converts the price implied by the discount basis into a yield which is directly comparable to that of other investments.
- Call: The right of the bond issuer to redeem a bond before its maturity date.
- Commercial Paper: Commercial paper is an unsecured promissory note issued for a specified amount. This security may carry a maturity of up to 270 days. However, the bulk of the issues mature within 30 days or shorter.
- Convexity: The convexity of a bond measures the curvature of the price/yield relationship of a bond’s cash flows. The larger the convexity, the steeper the curvature of the price/yield curve. This behavior is more evident for large changes in yield.
- Coupon: The coupon rate is the annual rate of interest on the bond’s face value that the issuer agrees to pay the holder until maturity.
- Current Yield: The current yield of a bond is the annual coupon divided by the market price of the bond. It is an inadequate measure of yield because it takes into account neither the entire amount nor the timing of the cash flows of a bond.
- Face Value/Par Amount: The face amount, or face value, of a security is the amount the issuer pays the holder at maturity. Different security types have different face value denominations. Most bonds are quoted in multiples of $1000 face value. For example, 50 bonds would be equivalent to holding $50,000 face value of a bond.
- IRR: The “internal rate of return” is the discount rate which equates the present value of the future cash flows of an investment to the cost of the investment. Hence, the net present values of cash outflows and cash inflows equal zero when IRR is used as the discount rate. The yield to maturity is an IRR.
- Odd Lot: Bonds trade at the less than normal trading units.
- Option Adjusted Spread (OAS): The spread over the Treasury spot curve which equates the present value of a bond’s cashflows to its market price, incorporating the fact that the bond’s cashflows may change under different interest rate environments.
- Settlement Date: Settlement date is the date when a security and the payment for it are actually exchanged between buyer and seller. It is also commonly known as the valuation date.
- Volatility: A relative measure of how rapidly the price of a security falls or rises within a short period of time.
- When Issued: Term for a Treasury bond transaction conditionally made because the bond, although authorized, has not yet been issued.
- Yield: Also known as “yield to maturity”, yield is defined as the internal rate of return of a security’s cash flows. It is that discount rate which equates a bond’s invoice price (principal + accrued interest) with the present value of its coupon and principal payments.
- Yield to call: The yield to call is the interest rate that will make the present value of the cash flows equal to the price paid for the bond if it is held to it first call date.
- Zero Coupon Bond: A bond that pays no periodic interest and sold at a deep discount from the face value. Buyer’s rate of return comes from the gradual appreciation on the bond.
Some data in this presentation was retrieved from Bloomberg LP, Ibbotson and www.bondtalk.com. We thank them for their very useful information.
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