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Alliance Trust Asset Management Monthly Income Bond Fund - Glossary of Terms A | B | C | D | E | F | G | H | I | J | K | L | M | N | O | P | Q | R | S | T | U | V | W | X | Y | Z
Bond A bond is an instrument which is used by companies (corporate bonds) and governments (gilts) to raise money. The money raised is lent on specific terms - for a fixed period of time and for a fixed income, known as a coupon (see below). The income received is often referred to as the yield. When the bond matures (see below Maturity Date), investors will receive the par value (see below Face Value) of the bond back. Back to top Bond Future A contractual obligation for the contract holder to purchase or sell a bond on a specified date at a predetermined price. A bond future can be bought in a futures exchange market and the prices and dates are determined at the time the future is purchased. Back to top Coupon The coupon represents the regular payments made throughout the life of a bond. Frequency of payment varies by country but are normally either bi-annual (UK and US) or annual (Europe). Back to top Credit Instruments Credit markets include a wide variety of bond and other types of loan instruments denominated in different currencies issued by governments and corporations. The borrowers can be domiciled anywhere in the world and the instruments can be denominated in any currency. Once a bond is issued it is traded on the markets and its price will vary from day to day as investors take into account new economic information such as interest rates or events affecting the quality of the issuer. Back to top Credit Quality Many bonds are rated according to credit quality as judged by rating agencies such as Standard & Poor's or Moody's. Credit ratings vary from AAA/Aaa which are regarded as high quality to D (in default). The different ratings reflect the ability of issuers to pay the agreed coupons and to repay the capital. Back to top Credit Rating A credit rating estimates the credit worthiness of an individual, company or country. It is based on an evaluation of a potential borrower's overall credit history and ability to repay debt, prepared by a credit rating agency. Credit ratings are calculated from financial history and current assets/liabilities. Typically a credit rating assesses the probability of the borrower being likely to pay back a loan. A poor credit rating indicates a high risk of defaulting on a loan and leads to higher interest rates on bonds. Back to top Credit Rating Agency A credit rating agency is a company which assigns credit ratings for issuers of certain types of debt instruments as well as to the debt instruments themselves. In most cases, the issuers are companies, state and local governments or national governments. The most widely quoted credit rating agencies are Moody's, Standard & Poor's and Fitch. Back to top Credit Risks Credit instruments are exposed to a mixture of government bond type risk and equity type risk. The risk bias in favour of one or the other depends on the perceived credit quality of the instrument. Safer corporate bonds will be more vulnerable to interest rate risk than to credit risk, i.e. changes in interest rate levels tend to be more important than the risk of default of the issuer. The weaker the perceived credit quality of the issuer, the higher the credit risk. High quality instruments are more like government bonds while lower quality bonds are more like equities. Back to top Currency of Issue If a bond instrument is issued in a currency other than an investor's base currency, the value of the instrument to the investor will fluctuate depending on the rate of exchange between the two currencies. (This can be hedged using derivatives - see below.) Back to top Derivatives Derivatives are commonly used in managing a portfolio of credit instruments. Derivatives can be used as a means of gaining exposure to an instrument or hedging against risks. Derivatives can be used to isolate one or more of the various risks embedded in credit instruments. For example, the interest rate risk can be hedged via derivatives leaving the portfolio sensitive to credit risk but insensitive to interest rate risks. Currency risks can also be reduced by using foreign exchange contracts so that an investment is not exposed to fluctuations between the bond instrument's currency of denomination and the investor's base currency. Back to top Distribution Yield The distribution yield is the coupon rate expressed as a percentage of the bond's price. It represents the ongoing return that an investor can expect from a bond's regular coupon. Also known as the Income or Running Yield. Back to top Duration Duration measures how quickly a bond will repay its true cost. The longer it takes to repay, the greater exposure the bond has to changes in interest rates. Investors who expect a rise in interest rates will want to lower the average duration of their bond portfolio. Factors which affect a bond's duration include: time to maturity and coupon rate:
2 bonds with the same capital cost and yield. A bond which matures in one year would more quickly repay its true cost than a bond which matures in 10 years. The shorter-maturity bond would have a lower duration and less price risk. The longer the maturity, the higher the duration. Coupon Rate A bond's coupon rate is a key factor in calculating duration. If two otherwise identical bonds pay different coupons, the bond with the higher coupon will pay back its original cost more quickly than the lower-yielding bond. The higher the coupon, the lower the duration. Face Value Face value is the amount the borrower agrees to repay when the bond matures. This is also known as the par value. Back to top Interest Rate Swap A swap in which the two counterparties agree to exchange interest rate flows. Typically, one party agrees to pay a fixed rate on a specified series of payment dates and the other party pays a floating rate that may be based on LIBOR (London Interbank Offered Rate) on those payment dates. Back to top Investment Grade Bonds These are bonds which have a low risk of defaulting. This means that investors can be confident that they will get their original money back and that the interest payments will be made. Anything rated lower than BBB- by S&P is considered a speculative or "junk" bond. Back to top Legacy Positions When a fund is large it is common for managers to own too much of an individual position and this can result in it being difficult to sell the stock and to reinvest the proceeds at a reasonable price. Back to top Liquidity The ease with which a bond can be bought or sold is an important market characteristic. The lower the perceived credit quality of an instrument, the poorer its liquidity tends to be (in particular in falling markets). Back to top Maturity Date Maturity date is the date on which the face value of the bond is repaid. Back to top Underlying Yield The underlying yield is the total return expected, taking into account both the distribution yield and also the capital gains/losses at redemption based on the original price paid for the bond. Also known as the Yield to Maturity or the Gross Redemption Yield. Back to top Yield Spread The yield spread is the difference in yield to maturity of a corporate bond and yield to maturity of a relevant high quality government bond. The difference reflects the market perception of the credit quality of the borrower. The yield spread is quoted in basis points, i.e. if the government bond yield is 5% and the corporate bond yield is 7%, the yield spread is quoted as being 200 basis points. Back to top |
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