Equity Indices with the laspeyres calculation methodologies can get complicated enough, but at least they tend to be linked to market movements and terminologies (TLA) that people understand. Fixed Income products however are a different ball game,so to assist we have attempted to put together a brief description / terminology of constructs used within fixed Income indices.
| Name | Description |
| Index Value | The index level that changes daily, usually starting from an arbitrary base amount of 100. It is used as a rough indicator of the return of the index |
| Divisor | The amount the market value needs to be altered by |
| Market Cap | Price multiplied by bond nominal gives its market value. This in turn rolls up to the index level market value which may or may not include coupon payments from the current month depending on the index vendors methdology |
| Index Currency | The currency that an index is denominated in, affecting the index and market values |
| Face value | The amount of money you get back upon redemption of a bond at maturity date. Typically $1000 |
| Maturity Date | The date at which a bond matures and your initial investment is repaid |
| Price | A bond price is usually expressed as a percentage of par. So a bond priced at 100 with a face value of $1000 will cost you $1000 to buy. If it’s priced at 90, you’ll pay $900 for a future repayment of $1000 |
| Yield | The return on your investment. There are many different ways of calculating this, but the most common is yield to maturity (YTM). It is influenced by interest rates external to the coupon you receive on the bond itself. |
| Macaulay Duration | The weighted average time in years until you receive back your initial investment into a bond. The oldest duration measure |
| Modified Duration | The amount a bond price will move for a 1% change in interest rates. Expressed as an annualised rate so will usually look very similar to Macaulay Duration but developed in the high interest rate environment of the 1970s to give further precision on the impact of future rate changes |
| Effective Duration | AKA option adjusted duration. Bonds with call features come with risk of the issuer calling in the debt early and reissuing at a lower rate. As interest rates fell in the 1980s, this risk was rising, so an enhanced duration measure taking embedded call options into account was developed |
| Held Cash / Investing Cash | An index will either hold cash paid as a separate weight and reinvest at the end of the month or reinvest it daily. A bond fund will typically hold more cash in reserves than an equity fund. This is because a fund manager may need to meet large redemptions and bond positions are not as easy to liquidate as equities |
| Call option | The option an issuer has to redeem debt early and reissue it at a lower interest rate |
| Put option | The option a buyer has to get their money back early |
| Coupon | Expressed as a percentage of face value, the amount of interest a bond will pay annually |
| Day count | The convention a bond accrues interest on. These range from simple assumptions such as 30 days in a month and 360 days in a year (30/360) up to more complex calculations such as taking into account the actual number of days in the period, accounting for holidays, leap years and so on (ACT/ACT) |
| Payment basis | How many times a year a bond pays out its coupon – this could technically be anything but annual, semi annual and quarterly are the most common |
| Default | A bond issuer defaults when they can no longer meet their obligation to make interest payments |
| Present Value | How much future money is worth now. Future bond coupons become worth progressively less as the purchase power of $1 falls over time so a present value is worked out by discounting (dividing) the future cashflow by an interest rate |
| Market Value | Face Value multiplied by price |
| Broker spread | Brokers will buy and sell bonds typically without a commission. Instead, they will make a spread on the buy and sell price instead |
| Payment in Kind (PIK) | Bonds that do not pay cash, but pay in bonds instead. This may be for the whole or part of the term |
| Pool Factor | The factor that an ABS bonds principal reduces by each month based on the underlying principal remaining |
| Asset backed | Bonds with cashflows determined by the payout of an underlying pool of assets such as mortgages. They can come with substantial risk if the credit quality of the underlying borrowers has not been analysed properly as this can lead to heightened risk of large defaults such as in the 2008 crisis. Mortgage backed securities (MBS) have two sub groups CMBS and RMBS for commercial or residential |
| Return | Bond indices are usually implemented in gross return versions. This contains both the capital appreciation from price movements and the return from coupons |
| Clean Price | The price of a bond excluding accrued interest for the period |
| Dirty Price | The price of a bond including accrued interest for the period. Bonds are usually quoted this way as the buyer will need to make the seller good on accrued interest they will miss out on when they sell the bond |
| Credit risk | The risk of default of a bond issuer. Corporations have much higher risk than governments because if they have trouble paying their debts, they cannot simply issue more debt or print more money like a government can. In turn, emerging market governments have much higher credit risk than western governments. |
| Issuer | The organisation responsible for selling the bond and making payments. This is usually a corporation or a government |
| Flat yield | Yield received if an investor buys and holds until maturity. Calculated as the annual coupon payment/Clean price*100% |
| Coupon yield | The most simple yield, effectively the amount a bond pays if it pays its coupons on time. Calculated as Annual coupon payment/Bond face value |
| Yield to maturity (YTM) | The expected return on a bond, if held to maturity and all payments are received on time and reinvested at the same rate of return. Assumes static interest rates so not always the most accurate measure, but the most widely used yield in bond analysis. Often calculated by trial and error, best deduced through bond yield tables or specific YTM calculators |
| Effective yield | Return using coupons reinvested at the same rate, found by dividing coupons by their associated bonds current market value |
| Convexity | Duration is good for small yield changes and is represented as a linear relationship between price and yield. However at the ends of the curve its observed that the rate at which price decreases as yield increases slows over time, but the rate at which price increases as yield decreases accelerates over time. As such, convexity adjustments are made to duration to give greater precision, making it the second derivative of price/yield, duration being the first |
| Bond future | A futures contract where a bond is delivered upon expiry |
| Cheapest to Deliver (CTD) | The bond that is literally ‘cheapest to deliver’ upon expiry of a bond future. CTD is calculated as current price – settlement price*conversion factor. The factors are released by the exchange the futures contracts are traded on, such as the CME Group |
| Yield curve | A representation of expected yields plotted against different maturity dates. These are used for many things including pricing new bonds against similar maturities and interest rate forecasting |
| Key Rate Durations (KRD) | Standard duration assumes that yield changes are the same along the whole of the curve. KRD instead shows the effect of the yield curve shifting in a non-parallel manner |
| Bond types | Many different bond types are available, in fact ‘bond’ itself is usually used as a generic term for fixed income but in some markets such as the US it specifically refers to longer dated fixed income investments. |
| Inflation linked (IL) | A bond with cashflows and principal payments linked to an inflation index. The cashflows are therefore variable |
| Floating Rate Note (FRN) | A bond that is linked to an interest rate. The cashflows are therefore variable and usually involve an interest rate uplifted bny a margin for example EURIBOR 3 Month + 25bps |
| Convertible | A bond that an investor can convert into underlying stock rather than hold to maturity. Coupons are given up in favour of dividends |
| Special Purpose Vehicle (SPV) | An entity created to issue asset backed securities |
| Credit Rating | Bonds carry a rating which amongst other things can be interpreted to show its risk of default. Governments, particularly western ones, tend to carry the lowest risk. AAA to BBB tends to be considered investment grade (high quality and low level of default risk). Lower than BBB will be labelled high yield or junk, with higher (sometimes extreme) risk of default. As such, BBB and lower will typically come with a high coupon to make up for the higher risk |
| Credit Ratings Agency | Moodys, Fitch, Standard and Poors issue credit ratings. |
| Interest rates | Market rates that are the biggest influence on bond pricing and trading. As rates go up, bond prices fall. This is because consumers will look elsewhere for new debt issued at higher coupons. Conversely, when rates fall bond prices go up because consumers are willing to pay more to access higher coupon rates that are no longer being issued |
| Yield to worst | The projected yield an investor will earn on an investment that has call options. YTW will show yield to the call date/dates rather than to maturity |
| When Issued (WI) | A bond that has not fully settled its terms that is open for auction, terms settling post-auction |
| Grey Market | Pre-issue trading market for bonds, usually over the counter (OTC) |
| Accrued interest | Bond carrying coupon rates pay out interest on specified dates. In between these dates, the interest slowly accrues each day until it reaches the full coupon amount on payment day. The accrued interest represents the percentage of the coupon accumulated so far in the period |
| Zero coupon bond | Bonds that do not pay a coupon. Investors make money on them as they are issued at a discount and pay their full face value on redemption |
| Spread | The difference in yield of a bond and a risk free rate, typically the yield of a government bond. Gives an important indicator of the level of extra return received for taking on the risk of a corporate issuer rather than a government |
| Option Adjusted Spread (OAS) | The same as spread but taking a bonds call features into account in the pricing model as well. Callable bonds have uncertain future cashflows so need further adjustments in analysis |
| Z spread/Static Spread | The rate that will make the bond price equal its cashflow present value, must be added individually to each point of the curve |
| I spread | Difference between the bond YTM and the yield of a similar bond on the same point of the yield curve |
