Bond: A promissory note issued by a business or governmental unit.
Treasury Bond: Bond issued by the federal government that are not exposed to default risk. Sometime referred to as government bonds.
Corporate Bond: A debt issued by corporations and exposed to Default Risk.
Municipal Bond: Issued by the state and local government. The interest earned on municipal bonds is exempt from federal taxes, and also from state taxes if the holder is a resident of the issuing state.
Foreign Bond: A bond sold by a foreign borrower denominated in the currency of the country in which the issue was sold.
Par Value: The nominal or face value of a stock or bond. The par value of a bond generally represents the amount of money that the firm borrows and promised to repay at some future date. It is often $1,000 to $5,000.
Maturity Date: The date when the bonds par value is paid back to the bondholder. Maturity dates generally range from 10 to 40 years from the time of issue.
Coupon Payment: The Dollar amount of interest paid to each bondholder on the interest payment dates.
Coupon Interest Rate: Stated rate of interest on a bond defined as the coupon payment divided by the par value.
b) Floating-rate Bond: A bond whose coupon payment may vary over time, the coupon rate is linked to the rate on another security such as a Treasury security or some other rate such as LIBOR.
Zero compound Bond: Pays no coupons at all but is provided at a substantial discount below its par value and hence provides capital appreciation rather than interest income.
Original Issue Discount (OID) Bond: Any bond initially offered at a price significantly below its par value.
c) Call Provision: Gives the issuing firm the right to call the bonds for redemption at a price greater than the par value. This increase in price is called the Call Premium.
Redeemable Bond: Gives investors the right to sell the bonds back to the corporation at a price that is usually close to the par value. If interest rates rise, investors can redeem the bonds and reinvest at the higher rates.
Sinking Fund: Facilitates the orderly retirement of a bond issue. This can be achieved in one of two ways. 1. The company can call for redemption at par value a certain percentage of bonds each year. 2. The company may buy the required amount of bonds on the open market.
d) Convertible Bond: A security that is convertible into shares of common stock at a fixed price at the discretion of the bondholder.
Warrant: A call option issued by a company allowing the holder to buy a stated number of shares of stock from a company at a specified price. Warrants are generally distributed with debt or preferred stock to induce an investor to buy those securities at a lower cost.
Income Bond: Pays interest only if interest is earned. These securities cannot bankrupt a company. But from an investor’s standpoint they are riskier than other bonds.
Indexed (Purchasing Power) Bond: The interest rate of such a bond is based on an inflation index such as the consumer price index (CPI), so the interest paid rises automatically when the inflation rates rise, thus protecting the bondholders against inflation.
Premium Bond: When the going rate of interest is below the coupon rate a fixed rate bond is sold at a price higher than its par value or at a premium.
Discount Bond: When the going rate of interest is above the coupon rate, a fixed rate bond will sell below its par value or at a discount.
Current Yield: The annual coupon payment divided by the current market price.
Yield to Maturity (YTM): The rate of interest earned on a bond if it is held to maturity.
Yield to Call (YTC): The rate of interest earned on a bond if it is called. If current interest rates are well below an outstanding callable bonds interest rates then the YTC may be a more relevant estimate of expected return than the YTM, since the bond is likely to be called.
Reinvestment Risk: The risk associated with changes is interest rates at which an investor will receive on future securities.
Interest Rate Risk: Arise from the fact that bond prices decline when interest rates rise. Under these circumstances, selling a bond prior to maturity will result in a capitol loss, the longer term to maturity the larger the loss.
Default Risk: The risk that borrowers will not pay back the interest or principal on a loan as it becomes due.
Indenture: A legal document that spells out the rights of the bondholder and issuer.
Mortgage Bond: A bond for which the corporation pledges certain assets as a security. All such bonds are written subject to an indenture.
Debenture: An unsecured bond, and as such, it provides no lien against specific property as security for the obligation. Debenture holders are, general creditors whose claims are protected by properties not otherwise claimed.
Subordinated Debenture: Debentures that have claims on assets, in the case of bankruptcy only after senior debts as named in the subordinate’s debt indenture has been paid off. Subordinate debentures maybe subordinate to designated notes payable or to all other debt.
Development Bond: A tax-exempt bond sold by state and local governments whose proceeds are made available to corporations for specific uses (deemed by congress) to benefit society.
Municipal Bond Insurance: An insurance company guarantees to pay the principal and interest on a bond, should its issuer (municipality) default. This reduces the risk to investors who are willing to accept lower coupon rate for an insured bond issue compared to an uninsured issue.
Junk Bond: High-risk, High-Yield bond issued to finance leveraged buyouts, mergers, or troubled companies.
Investment-grade Bond: A bond with the rating of Baa/ BBB or above.
Real risk-free rate of Interest r*: That interest rate that equalizes the aggregate supply of, and demand and riskless securities in an economy with zero inflation. The real risk-free rate can be called the pure rate of interest since it is the rate of interest that would exist on very short-term, default-free U.S. Treasury Securities if the expected rate of inflation were zero.
Nominal rate of risk-free interest rRF: The real risk-free rate plus a premium for expected inflation. The short-term nominal risk-free rate is usually approximated by the U.S. Treasury bill rate, while the long-term nominal risk-free rate is approximated by U.S. Treasury bonds.
Inflation Premium (IP): The premium added to the real risk-free rate to compensate for the expected loss of purchasing power. It is the average rate of inflation rate over the life of the security.
Default Risk Premium (DRP): When a bond has default risk, a default risk premium is added to its risk-free rate to compensate investors for bearing default risk.
Liquidity: Refers to a company’s cash and marketable securities and to its ability to meet maturing obligations. A liquid asset is any asset that can easily be sold and converted into cash at its “fair” value. Active markets provide liquidity.
Liquidity Premium (LP): A liquidity premium is added to the real risk-free rate of interest, in addition to other premiums, if a security is not liquid.
Interest rate risk: Arise from the fact that bond prices decline when interest rates rise. Under these circumstances, selling a bond prior to maturity will result in a capitol loss, the longer term to maturity the larger the loss.
Maturity Risk Premium (MRP): The premium that must be added to the real risk-free rate of interest to compensate for the interest rate risk, which depends on a bonds maturity.
Reinvestment Rate Risk: Occurs when a short-term debt security must be “rolled over” If interest rates have fallen, the reinvestment of principal will be at a lower rate, with corresponding lower interest payments and ending values.
Term Structure of Interest Rates: The relationship between yield to maturity and term to maturity for bonds of a single risk class.
Yield Curve: The curve that results when YTM is plotted on the Y-axis and the years to maturity is plotted on the x-axis.
“Normal” Yield Curve: When the yield curve slopes upward it is said to be normal because it is like this most of the time.
Inverted “Abnormal” Yield Curve: A downward sloping yield curve.
