The basic idea of bond investments is easy to understand. You simply buy a debt obligation, or bond, from an issuer, collect regular interest payments over the life of the bond, and then get your principal back when the bond matures.
This may sound like a simple concept, but where investors run into trouble is trying to decipher some of the terminology used when bonds are discussed. With that in mind, here are 14 basic but important terms that all bond investors should know.
Interest rates written on squares of paper, with a question mark printed on the center square.
Image Source: Getty Images.
1. Par value
Par value is also known as the face value of the bond and is the amount the issuer promises to repay the holder upon maturity. The majority of bonds are issued with a par value of $1,000. So if you hold a 30-year Treasury bond until its maturity date, the U.S. government will give you back $1,000.
2. Price
Price and par value are often used interchangeably by novice investors, but they mean two different things. Price refers to how much is actually paid when a bond is purchased. For example, a company may issue bonds with a par value of $1,000 but may end up selling them at a discounted price to entice investors to buy them. Price can refer to the amount paid to buy a bond from an issuer, or from a third party.
If a bond's price, or asking price, is less than its par value, it is said to be trading at a discount. For example, a bond with a $1,000 par value that sells for $950 sold at a discount. Conversely, a bond whose price is greater than its par value is said to be selling at a premium. A $1,000 par value bond that sells for $1,100 would have been sold at a premium.
3. Issuer
A bond's issuer is the entity that is using the bond to borrow money, and that is responsible for paying the agreed-upon interest, and for eventually repaying the principle. Bond issuers can include, but are not necessarily limited to, the U.S. government, state and local governments, various government agencies, and corporations.
4. Coupon rate
The coupon interest rate is the interest rate paid by the bond issuer and is based on the par value of the bond. For instance, a $1,000 bond with a 6% coupon rate would pay $60 in interest each year. This is also known as the nominal interest rate of the bond.
5. Maturity
The maturity of a bond is the amount of time until the bond becomes due from the issuer. A 10-year Treasury note, for example, matures 10 years from the date it was issued. Upon maturity, the bond issuer repays the principle to the investor, and the bond ceases to exist.
6. Duration
This term is one of the reasons I decided to make this list in the first place. Duration is possibly the most often misunderstood terms by bond investors and is often confused with "maturity."
Duration is actually a somewhat advanced bond term that is used to describe a bond's sensitivity to interest rate fluctuations. The calculation is rather complex, and to be clear, this is not a metric that most retail bond investors need to worry about. The simple version is that duration (which is expressed in years) tells you how much a bond's price will go up or down in response to a change in interest rates.
As a basic example, if a bond's duration is six years, you can expect a 100-basis-point (1%) rise in interest rates to cause the market value of the bond to drop by 6%. If you want to learn more about bond duration, my colleague Jordan Wathen wrote a good primer on it a few years ago. For now, just know that bond maturity and bond duration mean two very different things.
7. Basis point
Speaking of basis points, one basic concept all bond investors should know is that a basis point is equal to one-hundredth of a percentage point, or 0.01%. In other words, if the 10-year Treasury bond yield is 3% and you hear that it went up by 12 basis points, that means that it rose to 3.12%.
8. Current yield
A bond's current yield tells you how much a bond is paying relative to its price, or current value. You can calculate current yield by dividing a bond's annual interest payments by its price. For example, if you pay $900 for a bond that pays $50 per year, the calculation shows that you're receiving a current yield of about 5.6%.
9. Yield to maturity
This is a bit of a complex calculation, and fortunately there are several capable yield to maturity calculators available online.
Essentially, yield to maturity tells you the effective yield you're going to get on your bond investments, if you hold them until they mature. This is a combination of the interest paid by the bond, the price you paid for it, and the discount or premium you paid to the par value that you'll get back upon maturity.
10. Callable bonds
If a bond is callable, that means the issuer has the option to buy back the bonds at a predetermined date before the maturity date, if it so chooses. Generally, if interest rates drop, or issuers can refinance their debt at a lower rate than they're paying on the bonds, there's a good chance the bond could be called early. Some bonds have several potential call dates that are important for investors to know.
11. Yield to call
For this reason, it's important to know the bond's yield to call. This is a similar calculation as yield to maturity and tells you your annualized bond investment returns if the issuer decides to exercise its option to call the bond.
12. Yield to worst
If a bond matures in say, 10 years, and there are three potential dates in the meantime when the bond could be called, that's a total of four possible dates your bond investment could come to an end, assuming you don't sell it.
So perhaps the most important yield concept to understand (and to ask your broker for) is known as the yield to worst. This calculation essentially compares all of the potential call dates and maturity dates to see which outcome produces the worst annualized rate of return. I always like to plan for the worst-case scenarios when investing, so by knowing your bond's yield to worst, you'll know the absolute lowest your return can be.
13. Zero-coupon bonds
A zero coupon bond does pay interest, but not at regular intervals like most bonds do. Instead, zero coupon bonds accumulate their interest over time and pay it as one lump sum at maturity. In practice, this is done by selling the bond at a massive discount to its par value.
14. Convertible bonds
Convertible bonds combine some features of stocks with some features of bonds. They generally function like standard bonds but have a provision where the holder can choose to convert the bond into shares of common stock at a certain exchange rate. Because of the upside potential, convertible bonds often pay lower interest rates than comparable bonds without the option of conversion.
Why are these terms so important to know?
If you invest bonds, you can't afford not to know the terminology. For example, if your broker says that they've found an excellent bond investment for you and quotes you a yield, does that mean the yield to maturity? The nominal yield? Yield to call? This can make a big difference when it comes to your actual investment returns and is critically important to know.
In a nutshell, knowing the terms on this list can make you a better-informed investor and can equip you to make wise financial decisions when choosing bonds to buy in your own portfolio.
