Glossary of Fixed Income Terms for Bonds and Securities Mastery

A. Glossary of Fixed Income Terms

Welcome to the comprehensive glossary of fixed income terms, designed to aid your understanding of bond markets, pricing strategies, and investment success. This glossary is an essential resource for those preparing for the US Securities Exams, providing clear and concise definitions of key terms used throughout the guide.

A

• Accrued Interest: Interest that has accumulated on a bond since the last coupon payment but has not yet been paid. It is important for calculating the bond’s price when it is sold between coupon payment dates.

• Agency Bonds: Debt securities issued by government-sponsored entities (GSEs) or federal agencies. They often offer higher yields than Treasury securities due to slightly higher risk.

• Amortization: The process of gradually paying off a debt over time through regular payments. In bonds, it refers to the gradual reduction of the bond’s principal.

• Asset-Backed Securities (ABS): Financial securities backed by a pool of assets, such as loans, leases, credit card debt, or receivables. They provide investors with cash flows from the underlying assets.

• Auction: A method used to issue government securities, where the price and yield are determined through competitive bidding.

B

• Basis Point (bps): A unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument, equal to 1/100th of 1%.

• Bid-Ask Spread: The difference between the highest price a buyer is willing to pay for a security (bid) and the lowest price a seller is willing to accept (ask). It represents the transaction cost in trading.

• Bond: A fixed income instrument representing a loan made by an investor to a borrower, typically corporate or governmental. Bonds have a defined term or maturity and pay interest, known as a coupon.

• Bond Indenture: A legal document outlining the terms and conditions of a bond issue, including the rights and responsibilities of the issuer and bondholders.

• Bullet Strategy: An investment strategy that involves buying bonds with similar maturities to target a specific point in time for cash flow needs.

C

• Callable Bond: A bond that can be redeemed by the issuer before its maturity date at a specified call price. This feature is typically exercised when interest rates fall.

• Collateralized Debt Obligation (CDO): A structured financial product backed by a pool of loans and other assets, divided into tranches with varying risk levels.

• Convexity: A measure of the curvature in the relationship between bond prices and yields, indicating how the duration of a bond changes as interest rates change.

• Coupon Rate: The annual interest rate paid by the bond’s issuer, expressed as a percentage of the bond’s face value.

• Credit Default Swap (CDS): A financial derivative that allows an investor to “swap” or offset their credit risk with that of another investor.

D

• Day Count Convention: A system used to calculate the amount of accrued interest or the present value of a bond. Common conventions include 30/360, actual/actual, and actual/360.

• Default Risk: The risk that a bond issuer will fail to make the required interest payments or repay the principal at maturity.

• Discount Rate: The interest rate used to calculate the present value of future cash flows. It reflects the opportunity cost of capital and the risk associated with the investment.

• Duration: A measure of the sensitivity of a bond’s price to changes in interest rates, expressed in years. It estimates how much the price of a bond will change for a 1% change in interest rates.

E

• Effective Yield: The yield on a bond that takes into account the effects of compounding over a given period.

• Emerging Market Debt: Bonds issued by countries with developing economies, often offering higher yields due to increased risk.

• Eurobond: A bond issued in a currency not native to the country where it is issued, often used to raise capital in international markets.

• Ex-Ante Yield: The expected yield on a bond based on anticipated future interest rates and economic conditions.

F

• Face Value (Par Value): The nominal value of a bond, typically $1,000, which is paid back to the bondholder at maturity.

• Floating Rate Note (FRN): A bond with a variable interest rate that adjusts periodically based on a benchmark interest rate.

• Forward Rate: An interest rate applicable to a financial transaction that will take place in the future, often derived from the yield curve.

• Futures Contract: A standardized legal agreement to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future.

G

• General Obligation Bond (GO Bond): A municipal bond backed by the full faith and credit of the issuing government entity, supported by its taxing power.

• Government-Sponsored Enterprise (GSE): A financial services corporation created by Congress to enhance the flow of credit to specific sectors of the economy, such as housing.

• Green Bond: A bond specifically earmarked to be used for climate and environmental projects, promoting sustainability.

• Gross Domestic Product (GDP): The total value of goods produced and services provided in a country during one year, used as an indicator of economic health.

H

• Hedging: A risk management strategy used to offset potential losses in one investment by making another investment.

• High-Yield Bond (Junk Bond): A bond with a lower credit rating and higher risk of default, offering higher yields to compensate for the increased risk.

• Hybrid Security: A financial instrument that combines characteristics of both debt and equity, such as convertible bonds.

• Hypothecation: The practice of pledging assets as collateral for a loan without transferring ownership, commonly used in margin accounts.

I

• Immunization: A strategy to shield a bond portfolio from interest rate risk by matching the duration of assets and liabilities.

• Inflation Risk: The risk that the purchasing power of a bond’s future cash flows will be eroded by inflation.

• Interest Rate Risk: The risk that changes in interest rates will affect the value of a bond, with rising rates generally leading to falling bond prices.

• Inverse Floater: A bond or other type of debt whose coupon rate has an inverse relationship to a benchmark interest rate.

J

• J-Curve Effect: An economic theory that suggests a country’s trade deficit will initially worsen after a depreciation of its currency because higher prices on imports will be greater than the reduced volume of imports.

• Jumbo Bond: A bond issue with a particularly large principal amount, typically over $1 billion, often issued by governments or large corporations.

• Junk Bond: See High-Yield Bond.

K

• Kicker: An additional feature or benefit of a bond, such as a warrant or option, designed to make it more attractive to investors.

• Knock-In Option: A type of barrier option that comes into existence when the underlying asset reaches a certain price level.

• Knock-Out Option: A barrier option that ceases to exist when the underlying asset reaches a certain price level.

L

• Ladder Strategy: An investment strategy that involves purchasing bonds with different maturities to reduce interest rate risk and provide liquidity.

• Leverage: The use of borrowed funds to increase the potential return on investment, which also increases risk.

• Liquidity Risk: The risk that an investor might not be able to buy or sell a security quickly enough to prevent or minimize a loss.

• Long Bond: A bond with a long maturity, typically 10 years or more, often used as a benchmark for long-term interest rates.

M

• Macaulay Duration: A measure of the weighted average time until a bond’s cash flows are received, used to assess interest rate risk.

• Market Segmentation Theory: A theory that explains the shape of the yield curve based on the demand and supply for bonds in different maturity segments.

• Maturity Date: The date on which the principal amount of a bond is to be paid in full to the bondholder.

• Municipal Bond: A bond issued by a state, municipality, or county to finance its capital expenditures, often offering tax-exempt interest payments.

N

• Negative Covenant: A bond covenant that restricts the issuer from certain activities, such as incurring additional debt or selling key assets.

• Nominal Yield: The interest rate stated on a bond when it is issued, also known as the coupon rate.

• Non-Investment Grade Bond: A bond rated below BBB- by Standard & Poor’s or Baa3 by Moody’s, considered to have a higher risk of default.

• Notional Amount: The face value or principal amount used to calculate payments made on a derivative, such as an interest rate swap.

O

• Option-Adjusted Spread (OAS): A measure of the spread of a fixed income security rate and the risk-free rate, adjusted for embedded options.

• Original Issue Discount (OID): The discount from par value at the time a bond is issued, representing the interest that will be paid over the life of the bond.

• Over-the-Counter (OTC) Market: A decentralized market where securities are traded directly between parties, without a central exchange or broker.

• Outstanding Bonds: Bonds that have been issued and are currently held by investors, not yet matured or redeemed.

P

• Par Value: See Face Value.

• Premium Bond: A bond trading above its face value, often due to falling interest rates or an improvement in the issuer’s creditworthiness.

• Price-to-Worst (PTW): A measure used to evaluate the worst-case scenario for a bond’s yield, assuming the bond is called or matures at the earliest possible date.

• Putable Bond: A bond that gives the holder the right to sell it back to the issuer at a specified price before maturity.

Q

• Quantitative Easing (QE): A monetary policy used by central banks to stimulate the economy by increasing the money supply, often through the purchase of government securities.

• Quick Ratio: A measure of a company’s ability to meet its short-term obligations with its most liquid assets, calculated as (Current Assets - Inventories) / Current Liabilities.

• Quoted Price: The current price at which a bond is trading in the market, often expressed as a percentage of its face value.

R

• Rating Agency: An organization that assigns credit ratings to issuers of debt securities, assessing their creditworthiness. Major agencies include Moody’s, Standard & Poor’s, and Fitch.

• Redemption Value: The amount paid to a bondholder at maturity, typically equal to the bond’s face value.

• Revenue Bond: A municipal bond supported by the revenue from a specific project, such as a toll road or airport, rather than the issuer’s general tax revenues.

• Risk-Free Rate: The theoretical rate of return on an investment with no risk of financial loss, often represented by the yield on government securities.

S

• Sinking Fund: A fund established by a bond issuer to retire a portion of the bond issue before maturity, reducing credit risk.

• Spot Rate: The current interest rate for immediate settlement of a financial transaction, often used to derive forward rates.

• Spread: The difference between two interest rates or yields, often used to assess the relative value of different securities.

• Structured Note: A debt security with a return based on the performance of an underlying asset, index, or rate, often involving derivatives.

T

• Tax-Exempt Bond: A bond whose interest payments are exempt from federal income tax, and sometimes state and local taxes, often issued by municipalities.

• Term Structure of Interest Rates: The relationship between interest rates and different maturities, often depicted as a yield curve.

• Treasury Inflation-Protected Securities (TIPS): U.S. government bonds that are indexed to inflation, providing protection against inflation risk.

• Treasury Yield Curve: A graph showing the yields of U.S. Treasury securities at different maturities, used as a benchmark for other interest rates.

U

• Underwriting: The process by which investment banks raise capital for issuers by selling new securities to investors, often involving the purchase and resale of the securities.

• Unsecured Bond: A bond not backed by any specific collateral, relying on the issuer’s creditworthiness and reputation.

• Utility Bond: A type of revenue bond issued by public utilities to finance infrastructure projects, often backed by the utility’s revenue.

• Upside Potential: The potential for an investment to increase in value, often used in the context of equity-linked bonds or convertible securities.

V

• Value at Risk (VaR): A statistical measure used to assess the risk of loss on a portfolio, estimating the maximum loss over a given time period at a certain confidence level.

• Variable Rate Demand Obligation (VRDO): A long-term municipal bond with a variable interest rate that can be reset periodically, often with a put option allowing the holder to sell it back to the issuer.

• Vasicek Model: A mathematical model used to describe the evolution of interest rates, often used in the pricing of fixed income securities.

• Volatility: A measure of the price fluctuations of a financial instrument over time, often used to assess risk.

W

• Weighted Average Life (WAL): The average time until the principal of a bond is repaid, considering the timing of all cash flows.

• When-Issued (WI): A transaction made conditionally because a security has been authorized but not yet issued, often used in the context of Treasury securities.

• Withholding Tax: A tax deducted at the source of income, often applied to interest payments on bonds held by foreign investors.

• Workout Period: The time frame during which a distressed bond issuer restructures its debt, often involving negotiations with creditors.

X

• X-Coupon: A term used to describe a bond that is trading without the right to the next coupon payment, often due to the bond being sold between coupon payment dates.

• X-Efficiency: A measure of a firm’s efficiency in using its resources, often used in the context of financial institutions.

• Xenocurrency: A currency that is traded in markets outside its domestic borders, often used in the context of foreign bonds.

Y

• Yield Curve: A graph showing the relationship between bond yields and maturities, often used to assess economic conditions and interest rate expectations.

• Yield to Maturity (YTM): The total return anticipated on a bond if it is held until it matures, accounting for interest payments and capital gains or losses.

• Yield Spread: The difference between the yields of two different bonds, often used to assess relative value and risk.

• Yankee Bond: A foreign bond issued in the United States and denominated in U.S. dollars, often used by foreign entities to raise capital in U.S. markets.

Z

• Zero-Coupon Bond: A bond that does not pay periodic interest payments and is issued at a discount to its face value, with the full face value paid at maturity.

• Z-Spread: A measure of the credit spread of a bond over the risk-free rate, accounting for the bond’s cash flows and interest rate volatility.

• Z-Score: A statistical measure used to assess a company’s financial health and predict the likelihood of bankruptcy.

• Zoning Bond: A municipal bond issued to finance infrastructure projects related to zoning and land development, often backed by property taxes.

This glossary is a foundational tool for mastering the complexities of bonds and fixed income securities. By familiarizing yourself with these terms, you will be better equipped to navigate the bond markets, understand pricing strategies, and succeed in your investment endeavors.

Bonds and Fixed Income Securities Quiz: A. Glossary of Fixed Income Terms

This glossary and quiz section are designed to reinforce your understanding of key fixed income terms and concepts, providing a solid foundation for mastering bonds and fixed income securities.