5 Bond Investing Terminologies - Simplified

Bond investing is an important part of any portfolio, especially if you’re retired and are looking to generate more stable returns on your portfolio. Investors can benefit from understanding the key concepts related to bond investing. Below are five key terminologies that all bond investors should be aware of.

Duration

Duration is a measure of a bond’s sensitivity to changes in interest rates. It is calculated as the weighted-average time to maturity of all the cash flows from the bond, adjusted for the present value of each cash flow. The greater the duration, the more volatile the bond’s price will be as interest rates change. This is the reason why GILT funds (which have a high duration) tend to fall heavily in value when the RBI starts to raise interest rates, and vice versa.

Yield to Maturity (YTM)

Yield to maturity is the rate of return an investor can expect when they purchase a bond and hold it until it matures. YTM takes into account the current market price of the bond, the face value of the bond, and the coupon payments received from the bond. For instance, if a bond’s price has fallen below its face value, it’s YTM will be higher than the coupon (read – interest) because on maturity, we would expect the issuer to pay back the face value plus the coupon payment.

Credit Risk

Credit risk is the risk that the issuer of the bond will not be able to make good on their debt payments in a timely manner. The higher the credit risk, the greater the potential for default and the lower the bond’s yield. Credit risks can lead to rude portfolio shocks for investors because they end up having to take “haircuts” on their investment value, sometimes to the tune of 30-50%.

Call Risk

Call risk is the risk that the issuer of a bond can call the bond early, meaning they can pay off the bond before its maturity date. This can be beneficial to the investor if interest rates have dropped since they purchased the bond, but it can also be detrimental if it causes the investor to miss out on the higher interest rates that would have been available with a longer maturity.

Reinvestment Risk

Reinvestment risk is the risk that the investor will not be able to reinvest coupon payments or the proceeds from the sale of the bond at the same interest rate or better. For instance, you may be holding a 10% YTM bond but when it matures, bonds of the same credit quality are offering a 7% YTM. In this case, you’ll need to settle for a 3% less annualized return in case you’re planning to reinvest the maturity proceeds without upping the credit risk in your portfolio.

Bonds can be an important part of any portfolio, but understanding these key terminologies can help investors make informed decisions about their investments. Knowing the risks associated with investing in bonds and being aware of the key terms can help investors make better decisions when investing in bonds.