Municipal Bond Jargon - Hilton Head Monthly, November 2009
Bond performance has been in the news, with some sectors of corporate and high yield municipal tax-free bonds providing stock market like returns in 2009. With the upsurge of interest, it is worthwhile to review some of the terminology and formula knowledgeable bond investors need to understand.
Our example will be a $1,000 AA1/AA rated 5% Lexington County General Obligation Municipal tax free bond, selling for 108, maturing on February 1, 2029. Yield to maturity (YTM) is 4.378%. The bond is callable on February 1, 2016 at par. Yield to call is 3.563%.
Coupon- The coupon, or coupon rate printed on the bond, is 5%.
Income- The coupon times the par value (.05 X $1,000 or $50 per year).
Maturity- The date, February 1, 2029, that the bond will pay back $1,000, par value to the bondholder.
Par- the value of the bond at issue, usually $1000, often expressed as a percentage (i.e. 100, or 100%)
Price- Municipal bonds prices are quoted in percentages, not dollars. For example, a price of 100 means 100% of par; a price of 98 means 98% of par, or $980. In our example, the price is 108. (One hundred and eight percent of par value of $1,000, or $1,080 per 1,000 of face value.)
Discount- When you pay less than par or $1000 for a bond, you’re buying it at a discount. If you hold the bond until maturity, the difference between what you paid (the discount) and what you receive is taxable, even if the bond itself is tax free. An amount of the discount is accreted each year. There are exceptions, however.
Premium- Paying more than par for a bond. In our example, you paid $1,080 (108 percent of par) for the bond. An amount of the premium is amortized each year; however, you don’t get any tax write-off.
Call- Usually an option by the bond issuer to redeem the bond before maturity. In our example, the bond can be called in 2016, well before its 2029 maturity date, at par.
Yield to Maturity (YTM)- The yield to maturity, or 4.378%, is the real return you receive on a bond investment, taking into consideration discount or premium paid, coupon, and time to maturity. It’s a complex calculation that requires a financial or bond calculator. However, it’s perhaps the single most important value to a bond investor, unless, as in our example, the bond is selling at a premium and is callable. In that case, the most important rate for you would be yield to call.
Yield to Call (YTC)- When you buy a premium bond, the length of time until maturity affects your true yield. If a bond you purchased at a premium could be called prior to maturity at less than your cost, the yield to call will be lower than the yield to maturity, and must be quoted as the definitive yield, in this case 3.563%
Taxable Equivalent Yield- A means of comparing taxable and tax free investments. By subtracting your marginal tax bracket (let’s say 28%) from 1, and dividing the results by the yield to maturity, you can compare the tax free bond in our example with a government bond or CD. For example, (1)-.28=.72. Now divide our yield to call (3.563%) by .72 to produce a taxable equivalent yield of 4.94%. You would have to receive a return of 4.94% on a taxable investment like a CD, to equal the tax free return of 3.563%.
General Obligation Bond- This signifies that the source of repayment and security for the bond is from the general assets and taxing powers of the issuing entity, and not a particular project. In our example, the bond is a general obligation of Lexington County and backed by the taxing authority of Lexington County.
Rating- Several rating agencies, among them Standard & Poor’s, Moody’s, and Fitch, are paid by states and municipalities to examine the security behind a particular bond issue and rate it accordingly.