Fixed Income Basics: Understanding Bond Investment Terms

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Difficulty: Easy

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Sorry, why learn about fixed income?

Bonds are not sexy, it’s an asset class founded for the retiring age group who needs a boring stable income….would be the stereotypical view. So why learn about it?

Well, for one, bond and equity markets are interlinked. I hope the below picture partially answers the question. It shows the annual issuance of fixed income securities (blue bars) compared to annual issuance for stocks (green bar) in USD billions. When bond markets sneeze, stock markets tend to catch a very bad cold…

Let’s just say the Bond Market >>> Equity Market. The difference in global market cap of the stock market and global fixed income market is “just slightly less stark”, just about the annual cumulative GDP of the US + China…

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Now for bond terms, let’s go through a real example

Very often, investors look at bond yields to decide if stock markets are relatively cheap or expensive. For example, comparing 10-year treasury yields vs dividend yield of the S&P 500 Index OR comparing BBB-rated corporate bond credit spreads vs S&P 500 earnings yield (earnings divided by index price) over time.

With that said, I hope you find the below example useful in understanding how to interpret a bond investment.

Example of a bond with its key investment terms

The above table shows what you might see being sent across by your financial advisor. I will explain what the terms in the columns above means:

Terms that help you IDENTIFY the bond

• ISIN: Unique reference number that allows for easy identification of a security
• Issuer: Company issuing the bond. Sometimes, there is also a guarantor, in which case the bond’s credit risk may be deemed to be the better of the issuer or guarantor.
• Currency: In what currency is the bond traded in. the same company could issue bonds denominated in different currencies
• Coupon: How much “interest” the bond pays per year. The coupon may be a fixed rate or floating rate. Coupon payment schedule is most commonly quarterly, semi-annual or annual. Zero-coupon bonds do not pay coupons and are issued at a discount to par.
• Maturity: When the bond expires and pays you back principal. Perpetual bonds, as the name suggests, do not have a maturity date.
• Credit Rating: Shows the “quality” of the issuer, higher rated bonds typically have lower risk of default. Bonds rated BBB- or higher are considered Investment-grade bonds.
• Rank or Subordination: Shows the priority of which the bonds rank in the capital structure of a company (secured, senior unsecured, subordinated, junior subordinated…in descending order of seniority). If a company has different ranked bonds, the more senior bonds will be paid back first in the event of a default scenario.

Terms that help you figure out the bond’s EXPECTED RETURN

• Price: The cost at which you are buying the bond at.
• Yield to maturity (YTM): Assuming the provided price, the annualized return of the bond to maturity, assuming no default. If you adjust the YTM with the expected risk of default, you get to the expected return of the bond assuming you hold the bond to maturity.
• Yield to call (YTC): Assuming the provided price, the YTC shows the annualized return of the bond to the nearest call date, assuming no default. A call feature allows the issuer to buy back the bond at a date earlier than the maturity date. If you adjust the YTC with the expected risk of default up till the call date, you get to the expected return of the bond assuming you hold the bond to up to the call date.
• Duration: Measurement of how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. It is more commonly used as an indication of how sensitive the bond price is to changes in interest rates (ie a duration of 5 would indicate that if the interest rate environment moves up by 1%, the bond price would approximately decline by 5%).

Special features the bond may have

• Next call: The earliest time the issuer may buy back the bond. Not all bonds are “callable”
• Call price: How much the issuer needs to pay to buy back the bond at the call date. High yield bonds sometimes have call prices above par.
• Coupon reset: Sometimes the bond coupon rate may be reset on a certain date onwards, most commonly to a benchmark rate (the above bond uses the 5 year US Treasury yield) + fixed rate spread (to compensate the investor for taking corporate credit risk).

Other information that you’ll need to know

• Issue size: Total amount that was issued for this bond. A larger issue size is usually preferred due to better secondary market liquidity (easier to transact the bond at tighter bid-ask spreads)
• Min Piece: The minimum denomination to trade the bond. Most bonds trade in min sizes of USD 200k. However the US has a developed bond market for retail investors, so it is not difficult to find bonds trading in min sizes of USD 1k.

In the following topics, we will examine more advanced topics, including a discussion on expected returns on debt investments, callable/puttable bond features, convertible bonds, floating rate bonds, leveraged bond investing, TLAC (total loss-absorbing capacity) vs Cocos (Contingent Convertibles) and more…