Debt Securities

The vocabulary

Par value, also called face value or principal, is conventionally $1,000 for a corporate or municipal bond. It is the amount repaid at maturity and the base for the coupon.

The coupon, or nominal yield, is the annual interest as a percentage of par, and it never changes for a fixed-rate bond. A 6 percent bond pays $60 a year, conventionally in two semiannual payments.

Maturity is when principal is repaid. A term bond has one maturity date; a serial bond matures in instalments, which is the standard municipal structure.

Corporate and municipal bonds are quoted as a percentage of par, so a quote of 98 means $980. Government notes and bonds are quoted in thirty-seconds, so 98:16 means 98 and a half percent of par, or $985.

Interest accrues to the seller up to but not including settlement, and the buyer pays it on top of the price. Corporate and municipal bonds accrue on a 30/360 basis; government securities on actual/actual.

Three kinds of bond trade flat, without accrued interest: zero-coupon bonds, income bonds, and bonds in default.

Price, yield and the four measures

A fixed-rate bond's price and its yield move in opposite directions. The coupon is fixed in dollars, so the only way to deliver a higher return to a new buyer is for the price to fall.

A bond above par is at a premium and yields less than its coupon; below par it is at a discount and yields more.

Two characteristics amplify the price response to a rate change: longer maturity and lower coupon. Combine them and you get the most volatile ordinary bond, a long-dated zero.

The four yields:

Nominal yield is the coupon rate — annual interest over par.

Current yield is annual interest over the current market price.

Yield to maturity accounts for the coupon, the price paid and the gain or loss at maturity.

Yield to call runs the same calculation to the call date and the call price.

The ordering rule answers most questions without any arithmetic. For a discount bond the four ascend in that order: nominal, current, yield to maturity, yield to call. For a premium bond they descend in the same order. At par all four are equal.

Corporate debt and ratings

Secured debt pledges specific assets. Mortgage bonds are secured by real property; equipment trust certificates by movable equipment such as railcars and aircraft; collateral trust bonds by securities the issuer owns.

Unsecured debt is a debenture, backed by the general credit of the issuer. Subordinated debentures rank behind other unsecured debt and pay more for it. Most large-company debt is debentures, so unsecured is not a synonym for risky.

Special types: convertible bonds, exchangeable for common at a stated ratio and paying a lower coupon in exchange; zero-coupon bonds, issued at a deep discount with no periodic interest; income or adjustment bonds, which pay interest only if earned and trade flat; and guaranteed bonds, backed by a third party such as a parent company.

Callable bonds may be redeemed early by the issuer, which happens when rates have fallen — exactly when the holder least wants it. A call feature therefore requires a higher yield. A sinking fund provision, under which the issuer sets money aside to retire the issue progressively, reduces credit risk and therefore yield.

Ratings from Moody's, Standard and Poor's and Fitch express an opinion about default risk. The investment-grade boundary is Baa3 at Moody's and BBB- at S&P and Fitch; below that is high yield, colloquially junk. A rating says nothing about interest rate risk: a AAA thirty-year bond can lose a great deal of value when rates rise without any change in its rating.

Money market instruments

Money market instruments are short-term, high credit quality and liquid, and they are the standard answer to a customer needing capital preservation or a short, specific time horizon.

Commercial paper is unsecured short-term corporate debt issued at a discount, with a maximum maturity of 270 days — the limit that keeps it inside the Securities Act's exemption for short-term notes arising out of a current transaction.

A negotiable certificate of deposit is a large-denomination bank time deposit that can be sold before maturity. A brokered CD is distributed through a broker-dealer, passes FDIC insurance through to the issuing bank, and is sold in the secondary market rather than redeemed early — so it can be sold below par if rates have risen.

A banker's acceptance is a time draft accepted by a bank, used to finance international trade.

A repurchase agreement is a sale of securities with an agreement to buy them back at a higher price on a stated date — economically a secured loan, and the instrument through which the Federal Reserve conducts open market operations.

Federal funds are overnight loans of reserves between banks.

A money market fund invests in these instruments and is managed to a stable value per share. It is a security, not a deposit, and it is not FDIC-insured.