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Bond Terminology

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Joseph Davis’ article explains various scenarios for interest rates. For those of you unfamiliar with some of the common terminology used to explain bonds, here is a brief primer.

Duration: A measure of how sensitive a bond is to changes in interest rates. (Bond prices are inversely related to yields. As yields rise, bond prices fall. As yields fall, bond prices rise.) Duration is calculated from the present value of all future cash flows, which include coupon payments (scheduled interest payments based on the terms stipulated in the bond) and the price at which the bond will be sold or redeemed. Duration is displayed as number of years, with lower-yielding bonds having a duration closer to the number of years until maturity than higher-yielding bonds. A higher level of duration implies a greater volatility in a bond’s price. Duration, however, is typically less than a bond’s maturity because of the flow of coupon payments. (The one exception is zero-coupon bonds, where duration equals maturity.)

Forward Rate: An estimate of bond yields at some point in the future, it is the market forecast level of what interest rates will be. The forward rate can be derived from the yield curve, using bonds of different maturities (e.g., a six-month and a one-year bond).

Maturity: A specified date for when the bond is to be redeemed. At redemption, the entire face value of the bond (e.g., $1,000) will be repaid.

Spot Rate: Spot, when used for describing an investment, is the current price. A spot rate, therefore, is the interest rate implied by the price at which bonds are currently trading.

Yield Curve: A chart that shows interest rates at a specific point for bonds (such as Treasuries) with different maturities. A yield curve is considered to be “steep” (upward sloping) when long-term rates are notably higher than short-term rates. This is a sign that traders expect interest rates to rise in the future, typically because of forecasted higher inflation. A yield curve is referred to as being “flat” when there is not a significant amount of difference between short-term and long-term rates. This occurs when expectations for inflation are stable. Finally, a yield curve is “inverted” (downward sloping) when long-term rates are below short-term rates. This signals that traders expect interest rates or inflation to decline in the future.

Yield-to-Maturity: The fully compounded rate of return on a bond that is held to maturity, assuming all interest and principal payments are made. Yield-to-maturity calculates interest income, price changes and the total cash flow received over the life of a bond.


Discussion

Phil from IL posted over 2 years ago:

New investor here and excuse me for my ignorance, but if yields fall while prices rise and as yields rise bond prices fall doesn't everything 'even' out?


Charles from IL posted over 2 years ago:

Phil-The answer is it depends. If you hold a bond until maturity, you get back the face value (par value) of the bond. Higher future yields allow you to reinvest the proceeds into a bond with higher interest rates. If you sell a bond before it matures, you may make or lose money depending on the direction of interest rates. Bond funds don't mature, so over the short-term, you will lose money on them as yields rise. Over the long-term, you should (but are not guaranteed)to be able to make up for the loss with higher dividend payments thanks to the higher yields.

-Charles Rotblut, AAII


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