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The Terminology of Bonds
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When examining bonds for your portfolio, you first need to understand the basic terminology that is used. We'll examine some key bond terms below.

Par Value

The par value is also known as the face value of the bond, which is the amount that is returned to the investor when the bond matures. For example, if a bond is bought at issuance for $1,000, the investor bought the bond at its par value. At the maturity date, the investor will get back the $1,000. The par value of bonds is usually $1,000, although there are a few exceptions.

Discount

Bonds do not necessarily trade at their par values. They may trade above or below their par values. Any bond trading below $1,000 is said to be trading at a discount.

Premium

Bonds may trade at a premium -- that is, more than the $1,000 par value. For example, a bond trading at $1,086.50 is said to be trading at an $86.50 premium per bond.

Coupon Interest Rate

The coupon rate is the interest rate that the issuer of the bond promises to pay the bondholder. If the coupon rate is 5%, the issuer of the bonds promises to pay $50 in interest on each bond per year (5% x $1,000).

Many bonds pay interest semiannually. If the issuer pays 5% semiannually, the bondholder would receive $25 per bond every six months. Some bonds have adjustable, or floating, interest rates, which are tied to a particular index. This means that the coupon payment will fluctuate based on the underlying index.

Maturity

The maturity of a bond is the length of time until the bond comes due and the bondholder receives the par value of the bond. For example, medium-term notes generally mature in one to less than ten years, while long-term bonds mature in ten years or longer.

Market Rates of Interest

Market rates of interest affect bond prices. This is illustrated with the following example.

Suppose you bought a bond last year with a coupon rate of 5%, when market rates of interest were also 5%, and you paid $1,000 per bond. This year, market rates of interest have risen to 6%.

What price would you get if you tried to sell this bond? Obviously, a buyer would not pay $1,000 for a bond yielding 5% when the buyer could buy new $1,000 bonds with current coupon rates of 6%. The buyer would expect to get at least 6%, which means that this bond will sell at a discount (less than $1,000) in order to be competitive with current bonds.

Conversely, if market rates of interest fall below the coupon rate, investors will be willing to pay a premium (above $1,000) for the bond. Thus, bond prices are vulnerable to market rates of interest (among other factors).

Call Provision

Many bonds have a call provision, which means that the issuer of the bonds can call, or redeem, the bonds at a specified price before their scheduled maturity.

Issuers exercise the call provision when market rates of interest fall well below the coupon rate of the bonds. Why? Because they can then issue new bonds at the lower rate of interest -- which costs them less in interest payments to bondholders.

Bid Price

Bonds are quoted on a bid and ask price. The bid price is the highest price buyers will pay for the bonds.

Ask Price

The ask price is the lowest price offered by sellers of the issue.

Spread

The spread is the difference between the bid and the ask price of the bond, part of which is a commission that goes to the broker or dealer. A large spread indicates that the bonds are inactively traded.

Basis Point

A basis point is one hundredth of one percentage point. For example, if the yield on a bond falls from 5.25% to 5.20%, then the yield has declined by five basis points. Basis points are used to measure the differences in bond yields.

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Risks

Please note that investing in bonds may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.

Excerpted from All About Bonds and Bond Mutual Funds by Esme Faerber. Copyright © 2000 by The McGraw-Hill Companies.

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