Bond Terminologies You Should Know

Contrary to popular belief, investing into bonds isn’t quite so simple! In fact, most investors don’t even understand the risks associated with bond investing, and equate them with fixed deposits. Here are a few terminologies you should be aware of before jumping on the bond-wagon!

Credit Rating

The “Credit Rating” of a bond stands out as its most advertised feature. Simply put, credit rating is a third-party stamp of approval that underscores the creditworthiness (or lack of it) of the debtor in question. CRISIL, ICRA and CARE are the chief agencies that issue ratings for Indian corporations. Bond ratings range from AAA (highest) to D (lowest), with D being an acronym for “Default”, the most dreaded term in all of bond-land. 

Government bonds, rated “SOV” or sovereign, are widely perceived as default-risk free and therefore supersede even AAA in terms of their creditworthiness. A thumb rule is: the higher a bond’s rating, the lower its coupon rate, and vice versa. Post the subprime mortgage fiasco of 2008, there have been questions raised on the objectivity of some global Credit Rating agencies since the industry follows an “issuer pays” revenue model; that is, bonds issuers pay credit rating agencies to rate them. 

Call/Put Provisions

Some bonds have inbuilt “call” provisions that permit their issuers to redeem them even prior to their maturity date. Intuitively, there’s an ironic flipside to this. After all, when is a bond issuer most likely exercise the call option? The answer is: after interest rates have fallen, so that they can re-price their outstanding debt by issuing lower interest bonds and reduce their own interest expenses. Unfortunately, this would leave the investor with no option other than to buy a lower interest bond to substitute the previous, higher interest one. For this very reason, callable bonds usually have higher coupons to compensate the investor for this possibility. Bonds that cannot be recalled prior to their maturity date are also called “bullet bonds”. 

Oppositely, some bonds have inbuilt “put” provisions that permit investors to sell the bond back to their issuers if they suddenly require cash, or after interest rates have risen. In the spirit of fairness, these bonds carry lower coupon rates, as compensation for the issuer who is at an obvious disadvantage!

Maturity, Yield & YTM

The maturity date of a bond is the date on which it becomes due for repayment by the issuer – if your bond has unluckily sunk to a “D” rating by then, you may be in for a rude shock. 

The yield on a bond is the annual rate of return that you’d earn from it; simply put, the annual coupon divided by the bond price. For instance, if you purchase a bond for Rs 105 that pays Rs 8 an annual coupon, the yield works out to 7.61 per cent; that is 8 per cent divided by Rs 105. This is why rising bond prices are synonymous with falling yields, and vice versa. 

The YTM or “Yield to Maturity” of a bond is the annualized yield that you’d realize if you held it until its maturity date. This is why the average YTM’s for bond funds surge when bond prices fall.

Credit Spread

Credit Spreads will be easy to grasp if you’ve understood yields. Basically, it’s is the difference between the yields of two bonds of similar maturities but different credit qualities. For instance, if the yield on the 10-year G Sec (Government Bond) is 6.5 per cent, and the yield on a 10-year corporate bond is 7.5 per cent, the credit spread between them is 1 per cent

Considering that rising yields are marked by falling bond prices, a widening credit spread isn’t good news for corporate bonds; it could be an early signal that the corporate borrower is headed for troubled times. Similarly, the narrowing of spreads spells good news for bond holders.