Bond terminology you need to know
Contrary to popular belief, investing in bonds is not so simple! In fact, most investors don’t even understand the risks associated with bond investments and equate them with fixed deposits. Here are some terminologies you should know before jumping on the bond wagon!
A bond’s “credit rating” stands out as its most advertised characteristic. Simply put, a credit score is a third-party stamp of approval that highlights the creditworthiness (or lack thereof) of the debtor in question. CRISIL, ICRA and CARE are the main agencies that issue ratings for Indian companies. Bond ratings range from AAA (highest) to D (lowest), with D standing for “Default”, everyone’s bond world’s most dreaded term.
Government bonds, rated “SOV” or sovereign, are widely perceived as having no risk of default and therefore replace even AAA in terms of creditworthiness. A rule of thumb is: the higher a bond’s rating, the lower its coupon rate, and vice versa. After the subprime mortgage fiasco of 2008, questions were raised about the objectivity of some global credit rating agencies as the industry follows an “issuer pays” revenue model; that is, bond issuers pay rating agencies to rate them.
Some bonds have built-in “call” clauses that allow their issuers to redeem them even before their maturity date. Intuitively, there is an ironic flip side to this. After all, when is a bond issuer most likely to exercise the call option? The answer is: after interest rates fall, so that they can reprice their outstanding debt by issuing low-interest bonds and reduce their own interest charges. Unfortunately, that would leave the investor no choice but to buy a low-yield bond to replace the previous, higher-yielding one. For this very reason, callable bonds generally have higher coupons to compensate the investor for this possibility. Bonds that cannot be called before their maturity date are also called “bullet bonds”.
In contrast, some bonds have built-in “sell” clauses that allow investors to sell the bond back to their issuers if they suddenly need cash or after interest rates have risen. In the spirit of fairness, these bonds come with lower coupon rates, in compensation for the issuer who is clearly disadvantaged!
Maturity, yield and YTM
A bond’s maturity date is the date on which it must be repaid by the issuer – if your bond has unfortunately fallen to a ‘D’ grade by then, you could be in for a severe shock.
The yield on a bond is the annual rate of return you would get from it; in simple terms, the annual coupon divided by the price of the bond. For example, if you buy a bond for Rs 105 which pays Rs 8 an annual coupon, the yield is 7.61%; this is 8 percent divided by Rs 105. This is why rising bond prices mean falling yields, and vice versa.
The YTM or “Yield to Maturity” of a bond is the annualized return you would get if you held it until its maturity date. This is why the average YTMs of bond funds rise when bond prices fall.
Credit spreads will be easy to understand if you understand yields. Basically, it is the difference between the yields of two bonds of similar maturities but of different credit qualities. For example, if the 10-year G Sec (government bond) yield is 6.5% and the 10-year corporate bond yield is 7.5%, the credit spread between them is 1%.
Considering that rising yields are marked by falling bond prices, a widening credit spread is not good news for corporate bonds; it could be an early signal that the borrowing company is heading for troubled times. Similarly, tighter spreads are good news for bondholders.