AMP Capital
Understanding Fixed Income – a glossary
Welcome to our educational series
Understanding Fixed Income – a glossary
About fixed income at AMP Capital
As one of the largest and most experienced fixed income
managers in Australia and New Zealand, we offer clients a wide
range of actively managed fixed income investments designed
to take advantage of market opportunities.
Our fixed income capabilities range from government bonds to
high–yield credit strategies, across domestic and global bond
markets. We also offer customised portfolio solutions across all
areas of the fixed income spectrum, tailored to individual client
risk and return needs.
Our size and reputation give us influence over pricing and terms
and conditions, helping to protect the interests of investors in
our funds.
For further information
Please visit www.ampcapital.com/fixedincome
Copyright, AMP Capital Investors Limited, 2013
Use, replication, quotation or reproduction of any part, or all, of this document, either
in printed, audible or digital form, is subject to written approval from AMP Capital
expressly authorising the usage and context of usage. Written permission must be
obtained by contacting Marketing Department, AMP Capital, Level 12, 50 Bridge Street,
Sydney NSW 2000, AUSTRALIA.
Table of contents
Types of fixed income investments
3
Glossary of fixed income investment terms 4
2
Different types of fixed
income investments can play
a role in almost any portfolio
It is essential that investors understand the risk and reward
characteristics of their chosen investment and allocate to
their portfolios accordingly. Here we look at some categories
and their differences – such as between corporate bonds and
hybrids – and provide a helpful glossary of generally used fixed
income terms.
Hybrids: A cross between debt and equity securities. They offer
the potential for capital appreciation and a steady income –
often in the form of a dividend – for a fixed period and can
then convert into underlying equity. As they are complex
instruments, displaying equity and bond–like characteristics,
investors should fully understand these assets and complete a
careful analysis of offer documents.
Corporate bond: One issued by a corporation, rather than a
government. They are lower down the risk spectrum than
hybrids but still offer attractive income due to their higher
perceived risk over government bonds.
Before making a choice between these two types of investment,
it pays to look at the main differences between them. The
following table compares the characteristics of common direct
securities with those of the AMP Capital Corporate Bond Fund in
five key areas:
Characteristics
Income
Diversification
Downside
protection
Risk
Liquidity
Toll roads/
Greenfield
Direct hybrid
security
Direct corporate AMP Capital
security
Corporate Bond
Fund (the Fund)
Very good,
Good, generally Good, pays
typically
fixed margin
monthly income
strongest
over a floating
income
base rate
No, unless
No, unless
Yes, holds 80+
individual
individual
bonds, no more
holdings are
holdings are
than 3% to 4%
kept to a low
kept to a low
of the portfolio
percentage
percentage
is in one security
Performs closer Low due to
Yes, as the Fund
to equities than floating rate
has duration
bonds
nature; low for
(interest rate
fixed rate bonds sensitivity)
Below equities
Less than
Less than
but above
hybrids and
hybrids and
corporate bonds equities –
equities
depends on
individual issue
Some, though
Some, though
Daily, with sell
subject to
subject
spread
positive market to market
conditions
sentiment
13% – 15%
3% – 5%
Medium/High
Income: While hybrids generally offer the strongest income
of all fixed income investments, their terms may differ widely.
Some hybrids pay dividends (including franking credits) while
others pay interest and they may also be priced differently
on conversion. For instance, they may convert to an ordinary
share at a fixed rate – such as one hybrid equals one share –
or at a variable rate, and some are not redeemable at all. The
distribution terms of corporate bonds are generally more rigid,
paying out income at regular intervals.
Diversification: Investing in a small number of direct securities
exposes a portfolio to concentrations of risk in issuers,
industries or geographies so a systemic event can impact a large
part of the portfolio. A corporate bond fund offers the benefits
of diversification across these factors, spreading portfolio risk.
An investment in hybrids generally means investing in just one
issuer, or a much smaller number of issuers.
Downside protection: Fixed rate bonds perform well when
interest rates are falling, which leads to an increase in the
price of a bond. This typically occurs when equity markets are
underperforming making them an effective portfolio diversifier.
On the other hand, floating rate corporate bonds do not have
this protection and are most heavily affected by movements
in the credit spread. Finally, because hybrids behave more like
equities than debt investments, the risks associated with them
are more equity–like.
Risk: If a company goes into bankruptcy, the first investors
to be paid are bond holders, then hybrid owners and finally
shareholders. The more subordinated the instrument, the
greater the price drop. Differences in pricing between retail and
wholesale markets occur from time to time, where a security’s
price can be too high or low for our understanding of the risk. In
the absence of bond ratings in the retail market, it is especially
difficult for investors to assess since a particular issue, or
structure being marketed, may have risks very different to the
senior debt of the same company.
Liquidity: Finally, unlike corporate bonds which are traded
daily, hybrids have an element of liquidity risk. Daily trading
volumes are usually enough for the individual investor to exit
the investment if their needs or views change but if all investors
change their views, the low level of daily liquidity means the
price impact to exit could be large.
These differences show that not all fixed income investments
are low risk or defensive investments. Investors who hold larger
amounts of investments such as hybrids should consider their
holdings as more equity–like and do their homework on the
structural elements and risks of each transaction.
Although hybrids can play a role in a well diversified portfolio,
investors seeking the defensive characteristics of traditional
fixed income investments, such as stronger performance
when equity markets are declining, portfolio diversification
and regular income, investing in a corporate bond fund may
be a more suitable option.
3
Glossary of fixed income investment terms
Accrued interest
Interest deemed to be earned on
a security but not yet paid to the
investor.
Ask price
Price being sought for the security by
the seller.
Asset backed
Bank capital
A collective term used for subordinated
bonds issued by the banking sector.
Basis point
One one–hundredth of a percentage
point. Yield differences among bond
securities are stated in basis points
(bps).
Bearer bond
A security that has no identification as
to owner. It is presumed to be owned
by the person who holds it. Bearer
bonds are freely negotiable since
ownership can be transferred quickly
from seller to buyer by delivery of the
instrument.
Bid
The price at which a buyer offers to
purchase a security.
Bond
A debt instrument, similar to an IOU.
It is a contract between the borrower
(issuer) and the lender (bondholder).
The issuer pledges to pay the loan
principal to the bondholder on a
fixed date (maturity date) as well as a
specified rate of interest during the life
of the bond.
Bond swap
Call
4
A bond or note backed by loan paper
or accounts receivable other than
mortgages.
The sale of a bond and the purchase of
another bond of similar market value.
Swaps may be made to establish a tax
loss, upgrade credit quality, extend or
shorten maturity, etc.
The repurchase of a bond by its issuer
before its maturity date, without
requiring the holder’s consent. If a
bond is callable, the date and price at
which it can be called is specified on
the certificate.
Callable bonds
Bonds which are redeemable by the
issuer prior to the maturity date at a
specified price at or above par.
Cap
The top interest rate that can be paid
on a floating rate note.
CDO (Collateralised Debt
Obligation)
A security backed by a pool of bonds,
loans and other assets. CDOs are
similar in structure to a collateralised
mortgage obligation (CMO) but do not
specialise in one type of debt.
CMO (Collateralised
Mortgage Obligation)
A security backed by a pool of
mortgage pass–through securities
or mortgage loans, which generally
supports several classes of obligations.
Collar
Upper and lower limits (cap and floor,
respectively) on the interest rate of a
floating rate note.
Collateralisation of
derivatives
Collateralisation is a process that
substitutes the credit risk of the
issuer of the collateral for that of the
counterparty to the transaction.
Convexity
A volatility measure for bonds.
Used together with duration,
convexity provides a more accurate
approximation of the gains and losses
on a bond or bond portfolio from a
change in interest rates rather than
using duration alone. The higher the
convexity, the greater the price gain or
price loss for a given change in interest
rates. Bonds with a longer maturity
will generally have a higher convexity,
and for instruments with the same
duration, the more dispersed the cash
flows, the greater the convexity.
Corporate bond
Also known as ‘credit’. A bond issued
by a corporate entity.
Coupon
Also known as ‘interest’. Annual
payout the borrower promises to pay
the bondholder during the life of the
bond. It is expressed as a percentage
of the bond’s par value. Most bonds
are still offered with a traditional fixed
rate, although floating rate notes and
zero coupon bonds are also common.
Credit
A collective term used for bonds issued
by corporate entities.
Credit rating
Designations used by credit rating
agencies to give relative indications of
credit quality.
Credit risk
The risk of loss to an investor due to
an issuer’s non–payment of interest or
principal on a bond.
Credit spread
Refers to the difference between
the yield of a corporate bond and a
government bond of the same maturity.
The actual spread of a corporate bond
versus a government bond is usually
referred to in terms of basis points
(bps). After purchasing a corporate
bond the bondholder may benefit
from a narrowing of the credit spread
which contributes to a smaller yield to
maturity. This drives up the price of the
bond, delivering a capital gain.
Glossary of fixed income investment terms
Credit spread duration
Credit spread duration measures the
sensitivity in the price of a bond to a 1%
change in credit spread. This is a useful
risk measure as it captures how much
a portfolio might lose if credit spreads
widen.
CSA
A Credit Support Annex (CSA) is
a document capturing collateral
arrangements that have been
negotiated between two parties that
trade OTC derivatives. The CSA is
attached to a standard ISDA document.
Current yield
Also known as ‘running yield’. It refers
to the annual payout as a percentage
of the current market price you actually
pay. For example, a bond with a current
market price of $1,000 that pays $80
per year in interest would have a current
yield of 8%.
Debenture
Default
Unsecured debt obligation, issued
against the general credit of a
corporation rather than against a
specific asset.
Failure to pay principal or interest when
due. Defaults can also occur for failure
to meet non payment obligations, such
as reporting requirements, or when a
material problem occurs for the issuer,
such as a bankruptcy.
Duration and yield
The chart below shows that as yields have moved lower,
duration has increased.
Source: AMP Capital, UBS as at July 2012
Duration of spread (DxS)
DxS is the credit spread duration times
spread. This is one of our preferred
measures of risk as it provides a more
detailed sensitivity of the impact
of changes in credit spreads on the
portfolio.
Embedded option
A provision within a bond giving either
the issuer or the bondholder an option
to take some action against the other
party. The most common embedded
option is a call option, giving the issuer
the right to call, or retire, the debt
before the scheduled maturity date.
Face value
Also known as ‘maturity value’, ‘par
value’, ‘principal’ and ‘redemption rate’.
The amount a bond or note will pay at
maturity.
Discount
The amount by which the purchase
price of a security is less than the
principal amount, or par value.
Floating rate note
A bond for which the interest rate is
adjusted periodically according to a
predetermined formula,
usually linked to LIBOR.
Discount note
Short–term obligations issued at
discount from face value, with
maturities ranging from overnight to
360 days. They have no periodic interest
payments – the investor receives the
note’s face value at maturity.
Floor
The lower limit for the interest rate on a
floating rate bond.
Government bond
Also known as a ‘sovereign bond’. A
bond issued by a government.
Gross redemption yield
Also known as ‘yield to maturity’. A
yield based on the assumption that
the security will remain outstanding
till maturity. It represents the total of
coupon payments until maturity, plus
interest on interest, and whatever gain
or loss is realised from the security at
maturity.
Hedge
An investment made with the intention
of minimising the impact of adverse
movements in interest rates or security
prices.
High grade
Also known as ‘investment grade’.
Bonds considered suitable for
preservation of invested capital by
credit rating agencies and rated Baa or
BBB or above.
High yield bond
Also known as ‘sub investment grade
bond’ or ‘junk bond’. Bonds issued by
lower rated corporations, sovereign
countries and other entities (Ba or BB or
below) and offering a higher yield than
more creditworthy securities.
Discount rate
The rate the Federal Reserve charges on
loans to member banks.
Duration1
Duration is an important measure of
risk in bond investing. It measures the
impact of a 1% change in yield on the
price of a bond.
5
Glossary of fixed income investment terms
Foreign ownership of AUD bonds has
never been higher
Australian bonds have been bought in increasing numbers
by offshore investors in recent years. This appetite has been
fuelled by several factors including the resilience of the
Australian economy relative to other developed markets,
relatively higher yields and the AAA credit rating status of
Australia’s sovereign debt. AAA rating as per Moody’s and
S&P.
Investment grade
Also known as ‘high grade’. Bonds
considered suitable for preservation
of invested capital by credit rating
agencies and rated Baa or BBB or above.
Issue date
The date of a bond issue from which
the first owner of a bond is entitled to
receive interest.
Issuer
An entity which issues and is obligated
to pay principal and interest on a debt
security.
Junk bond
Also known as ‘sub investment grade
bond’ or ‘high yield bond’. Bonds issued
by lower rated corporations, sovereign
countries and other entities (Ba or BB or
below) and offering a higher yield than
more creditworthy securities.
Leveraged loan
A loan provided to a company already
holding a considerable amount of
debt. Since the company being offered
the loan is already highly leveraged,
this type of loan carries more risk to
investors who, in return, require higher
rates of return.
LIBOR (London Interbank
Offered Rate)
The rate banks charge each other for
short–term loans. LIBOR is frequently
used as the base for resetting rates on
floating rate notes.
Liquidity
A measure of the relative ease and
speed with which a security can be
purchased or sold in the secondary
market at a price that is reasonably
related to its actual market value.
Macaulay duration1
This form of duration measures the
number of years required to recover
the true cost of a bond, considering
the present value of all coupon and
principal payments received in the
future. Interest rates are assumed to be
continuously compounded. It is the only
type of duration quoted in ‘years’. See
also ‘Modified duration’.
Maturity date
The date when the principal amount of
a security is payable.
Maturity value
Also known as ‘face value’, ‘par value’,
‘principal’ and ‘redemption rate’. The
amount a bond or note will pay at
maturity.
Modified duration1
This form of duration expands or
modifies Macaulay duration to measure
the responsiveness of a bond’s price to
interest rate changes. It is defined as
the percentage change in price for a 1%
change in interest rates. The formula
assumes that the cash flows of the
bond do not change as interest rates
change. See also ‘Macaulay duration’.
Money market
Market for short–term debt securities
with a maturity of one year or less, and
often 30 days or less.
Municipal bond
Bond issued by a state, city or local
government.
100%
80%
60%
40%
20%
0%
CGS
Kangaroos
Semis
Corporates
Banks
ABS
Source: RBA, ABS, Commonwealth and State Treasuries, CBA Estimates
Hybrid security
Interest
Also known as ‘coupon’. Annual payout
the borrower promises to pay the
bondholder during the life of the bond.
It is expressed as a percentage of the
bond’s par value. Most bonds are still
offered with a traditional fixed rate,
although floating rate notes and zero
coupon bonds are also common.
Interest rate swap
Financial derivatives used by banks and
other financial institutions for hedging
market interest rate risk. A conventional
swap comprises two legs, one fixed
rate and the other floating rate which
is referenced to an external reference
such as LIBOR. They are an important
asset–liability management and risk
management tool in financial markets.
See also ‘Swap spread’.
ISDA
6
A security that combines two or more
different financial instruments. Hybrid
securities generally combine both debt
and equity characteristics. In the field
of bank capital, ‘hybrid’ is often used to
refer to preferred securities.
International Swaps and Derivatives
Association (ISDA) is an association that
represents participants in the private
negotiated derivatives (OTC) market
and is the largest global financial trade
association, by number of member
firms. Since its inception, ISDA has
pioneered efforts to identify and reduce
the sources of risk in the derivatives and
risk management business. ISDA has
developed a standard contract called
the ISDA Master Agreement.
Glossary of fixed income investment terms
NAV
The Net Asset Value (NAV) reflects the
value of all securities in the portfolio
and will consequently tend to fluctuate
daily. When a position is expressed
as a per cent weight of NAV, this is a
meaningful measure of the risk of loss
to the portfolio in the event of a default.
Running yield
Also known as ‘current yield’. It refers
to the annual payout as a percentage
of the current market price you actually
pay. For example, a bond with a current
market price of $1,000 that pays $80
per year in interest would have a current
yield of 8%.
New issue
A bond being offered for sale for the
first time.
Secondary market
Market for issues previously offered or
sold.
Non–callable bond
A bond that cannot be called for
redemption by the issuer before its
specified maturity date.
Senior bond
Offer
The price at which a seller will sell a
security.
Over the counter
Over–the–counter (OTC) or off–
exchange trading is done directly
between two parties without any
supervision of an exchange. It also
refers to debt securities and other
financial instruments such as
derivatives, which are traded through a
dealer network.
Senior bonds have greater seniority
in the issuer’s capital structure than
subordinated bonds and preferred
securities. That is to say, in the event
the issuer goes bankrupt, senior debt
must be repaid before other creditors
receive any payment. Senior debt is
often secured by collateral on which the
lender has put in place a first lien.
Sovereign bond
Also known as a ‘government bond’. A
bond issued by a government.
Sub–investment grade
bond
Also known as ‘high yield bond’ or
‘junk bond’. Bonds issued by lower
rated corporations, sovereign countries
and other entities (Ba or BB or below)
and offering a higher yield than more
creditworthy securities.
Subordinated bond
A bond whose claim on income and
assets of the issuer in the event
of default (or if the issuer files for
bankruptcy) is ranked below the claims
of senior bonds. A subordinated bond
is paid after senior bonds but before
ordinary shares in a liquidation.
Swap spread
The difference between the swap
rate on a contract and the yield on a
government bond of the same maturity.
The spread itself is the number of basis
points the swap rate lies above the
equivalent maturity government bond
yield, quoted on the same interest
basis. The higher rate payable on
swaps represents the additional risk
premium associated with bank credit
risk compared to government credit
risk. Swap spreads are based on LIBOR
rates, the creditworthiness of the swap’s
counterparties and other economic
factors that could influence the terms of
the investment’s interest rates. See also
‘Interest rate swap’.
Transfer agent
A party appointed by an issuer to
maintain records of securities’ owners,
to cancel and issue certificates, and
to address issues arising from lost,
destroyed or stolen certificates.
Treasury bond
A bond issued by the US government.
Trustee
A bank designated by the issuer as
the custodian of funds and official
representative of bondholders.
Par value
Also known as ‘face value’, ‘maturity
value’, ‘principal’ and ‘redemption rate’.
The amount a bond or note will pay at
maturity.
Preferred security
A security possessing characteristics
of both equity and debt. Preferred
securities are generally longer–term in
maturity but have early redemption or
‘call’ features. Preferred securities have
been created by companies for their
favourable accounting treatments and
flexibility. See also ‘hybrid security’.
Premium
The amount by which the price of a
security exceeds its principal amount.
Primary market
The market for new issues.
Principal
Also known as ‘face value’, ‘maturity
value’, ‘par value’ and ‘redemption rate’.
The amount a bond or note will pay at
maturity.
Redemption rate
Also known as ‘face value’, ‘maturity
value’, ‘par value’ and ‘principal’. The
amount a bond or note will pay at
maturity.
Registered bond
A bond whose owner is registered
with the issuer or its agent. Transfer of
ownership can only be accomplished
when the securities are properly
endorsed by the registered owner.
Reinvestment risk
Revenue bond
The risk that interest income or
principal repayments will have to be
reinvested at lower rates in a declining
rate environment.
A municipal bond payable from
revenues derived from tolls, charges
or rents paid by users of the facility
constructed with the proceeds of the
bond issue.
7
Yield
The annual percentage rate of return
earned on a security. Yield is a function
of a security’s purchase price and
coupon.
Yield curve
A line tracing relative yields on a type of
security over a spectrum of maturities
ranging from three months to 30 years.
Yield to call
A yield on a security calculated by
assuming that interest payments will
be paid until the call date, when the
security will be redeemed at the call
price.
Yield to maturity
Also known as ‘gross redemption yield’.
A yield based on the assumption that
the security will remain outstanding
till maturity. It represents the total of
coupon payments until maturity, plus
interest on interest, and whatever gain
or loss is realised from the security at
maturity.
Zero–coupon bond
A bond on where no periodic interest
payments are made. The investor
receives one payment which includes
principal and interest at redemption
(call or maturity). See also ‘Discount
note’.
Source: ipac. The Securities Industry and Financial Markets Association (www.
investinginbonds.com), OECD Glossary of Statistical Terms, Investopedia.
1 California Debt and Investment Advisory Commission, January 2007.
Any ratings mentioned, i.e. High grade, “High yield bond”, “Investment grade”,
“Junk bond” and “Sub–investment grade bond”, are as per Moody’s and S&P.
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AMPC_Fixed Income glossary_050613
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