For investors, fixed-income holdings such as bonds can offer many benefits including lower risk, stable income streams and an opportunity to diversify their portfolio.
However, investors who are new to the world of fixed income, often find bonds hard to comprehend, in part because they have their own unique terminology. Understanding this can help to demystify the world of fixed income, so here’s a quick introduction to some of its most commonly used expressions.
When you buy a bond, you are lending money to an institution such as a company or a government. You become a bondholder making a loan to the bond issuer (Bonds are sometimes also referred to as ‘interest rate securities’, ‘debt securities’, ‘bills’ or ‘notes’).
Your loan is for a fixed amount, called the bond’s face value or par value. It is for a fixed period of time, known as its duration, and is repaid to you when the bond reaches its maturity date. It pays a predetermined rate of interest, called the coupon rate, and you will typically receive your interest payments quarterly or biannually.
Bonds issued by companies are referred to as corporate debt, and those sold by governments are known as sovereign debt. They are graded according to their quality by independent ratings agencies such as Standard & Poor’s and Moody’s, who give them ratings such “AAA” and “AA” (high quality) and “A” and “BBB” (medium quality).
Bonds issued by the United States of America (US) government are generally considered to be the safest investment of their kind and are called US Treasuries. Bonds of the lowest quality are often referred to as junk bonds. This is because there is a risk that the issuer may default, i.e. fail to make payments within the specified period.
Many bonds pay a set rate of interest that never changes. These are known as fixed-rate notes. However, the interest rate on floating-rate notes may go up or down over time and is generally linked to a benchmark interest rate (for example, the Reserve Bank of Australia (RBA) cash rate).
A bond is a liquid investment that can be easily bought and sold. However many factors such as its credit rating, which may change over time, and interest rates and inflation can have a big impact on a bond’s resale value and its yield, which is the profit the buyer expects to make on it expressed as an annual percentage. The higher the price paid for a bond, the less profit it will generate for its owner, so the lower its yield.
Other common bond-related terms
Basis point – A unit of measurement equal to 1/100th of 1%, or 0.01%. Often used when measuring changes in interest rates and bond yields.
Bank bill swap rate (BBSW) – An important interest rate benchmark for the Australian dollar that may be referenced by floating-rate notes.
Convertible bond – A bond that can under certain circumstances be converted into a predetermined number of shares in the issuing company.
Investment-grade bonds – Bonds with high gradings such as AAA, AA+, AA and AA- from the ratings agencies.
Fallen angel – A bond that was initially given an investment-grade rating but has since been reduced to junk status.
Perpetual bond – A bond with no maturity date that pays a steady stream of interest forever.
Senior debt – Senior bonds must be repaid first if a company goes out of business and generally ranks as highest priority in the capital structure.
Subordinated debt – Subordinated debt generally ranks above equity but after senior bonds in the capital stack.
Yield curve – A graph that shows the yields of bonds of differing maturities. It reflects investors’ expectations for interest rates in the future and generally slopes up, under normal market conditions
For more on fixed income and bonds, our Head of Investments – Fixed Income discusses to float or not to float >
This article was prepared by Trilogy Funds Management Limited ACN 080 383 679 AFSL 261425 (Trilogy) and does not take into account your objectives, personal circumstances or needs nor is it an offer of securities. Application for investment can only be made on the application form accompanying the Product Disclosure Statement (PDS) dated 17 December 2018 for the Trilogy Monthly Income Trust and available from www.trilogyfunds.com.au. The PDS contains full details of the terms and conditions of investment and should be read in full, particularly the risk section, prior to lodging any application or making a further investment. All investments, including those with Trilogy, involve risk which can lead to loss of part of or all your capital or diminished returns. Trilogy is licensed to provide only general financial product advice about its products and therefore recommends you seek personal advice on the suitability of this investment to your objectives, financial situation and needs from a licensed adviser to conduct an analysis based on your circumstances. Investments with Trilogy are not bank deposits and are not government guaranteed.