Investing in bonds can be intimidating for beginners. There are too many terminologies that can be confusing. But knowing these terms and their specific definitions is essential before taking a deep dive into the world of bond investing. This article lists and defines the important terms in bonds and their respective definitions.
A Definitive Guide to the Key Terms in Bond Investing and Their Respective Definitions
Beginners and even some investors have difficulty understanding the terms involved with bonds. There are several technical words used in the bond market. What exactly are coupon rates and bond yields? What is the difference between a call option and a put option? Understanding these terms is important to make informed decisions about buying, selling, or holding bonds, as well as managing risk and maximizing returns. Take note of the following:
• Bond: A bond or debenture is a debt instrument and a fixed-income security that represents the debt of a particular issuer to a particular individual or institutional investor. Issuing a bond means the issuer has borrowed funds for a defined period at a fixed or variable interest rate. There are different types of bonds. Some are categorized according to the nature of the issuer while others are categorized based on the specific characteristics or unique features of the bond.
• Issuer: The bond issuer pertains to the borrower who is indebted to the bondholder. The issuer issues a bond to raise funds or capital needed for its operations or to implement its strategies. Different entities can become bond issuers. Examples include corporations, governments, government institutions, municipalities, and banks.
• Bondholder: The bondholder is the lender who lends funds to the bond issuer through the bond market or via intermediaries such as investment banks. The bondholder is also called the bond purchaser and bond investor. There are different examples of bondholders. Individual bondholders are individual investors while institutional bondholders are institutional investors that include corporations, governments, government institutions, and investment firms.
• Principal: Purchasing a bond involves paying an amount to the bond issuer. This is called the principal and its amount is specified by the issuer. It is specifically defined as the amount of money the issuer of a bond is borrowing and will repay to the bondholder upon the maturity date. It is fundamentally the total amount borrowed from the bondholder or the initial amount invested by the bondholder.
• Face Value or Par Value: Note that the term “face value” or “par value” is derived from the “stated value” of a financial instrument. The face value of a bond is the amount a bondholder will receive once the bond he or she holds matures. Take note that the amount of the face value is similar to the amount of the principal.
• Coupon Rate: A bond issuer pays an annual interest rate to the bondholder. This interest rate is called the coupon rate. This rate is expressed as the percentage of the face value of the bond. The duration of coupon payment spans from the date of issuance until the date of maturity of a particular bond.
• Maturity Date: Each bond has a maturity date or maturity. This date represents the specific date when the principal amount of the bond becomes due and is repaid to the lender. This means that the bond issuer is required to repay the bondholder the face value of the bond. The maturity date marks the end of the life of the bond.
• Bond Price: The price of a bond or bond price is the current market value of a bond. It is different from the principal and the face value. The bond price represents how much someone is willing to pay for the bond on the free market. Take note that the face value is fixed while the bond price varies and is influenced by different factors such as the influence of supply and demand forces in the bond market.
• Yield: Remember that purchasing a bond is an investment. This means that bondholders purchase a bond to get a return on their investments or expect. It is also defined as the amount the bondholder is expected to receive each year. This return is called the yield. It is calculated by dividing the coupon rate by the bond price and is specifically expressed as the percentage of the invested capital of a particular bondholder.
• Yield To Maturity: The yield to maturity or YTM of a bond is the total rate of return that will have been earned by a bond when it makes all interest payments and repays the original principal. It simply describes and indicates how much a bondholder will make if he or she purchases a bond and holds it until it matures. YTM takes into account the amount of money invested, the amount of interest the bondholder will earn, and how long he or she has to wait until he or she gets the principal back.
• Call Option: A call option is a contract that gives the bond issuer the right to redeem the bond before its maturity date. This redemption is usually done at a premium price. Specifically, when an issuer calls a bond, it pays the bondholder the call price, which is usually based on the face value, together with accrued interest to date. Bonds that have an embedded call option are called callable bonds or redeemable bonds.
• Put Option: A put option is a contract that gives the bondholder the right, but not the obligation, to sell the bond back to the bond issuer before its maturity date at specified dates regardless of the reason. This is done at a specified price called the put price which is usually equal to the amount of the face value. Bonds that have an embedded put option are called puttable bonds or put bonds.
• Credit Rating: The credit rating is an evaluation that describes the ability of a bond issuer to repay its debt obligations. These obligations pertain to the specific capabilities of the issuer to release coupon payments and repay the principal or face value. The rating is determined by so-called credit rating agencies.