To understand Fixed Interest there are certain words that you need to become familiar with. To assist you, we have given you a quick description of what they mean below:
Accrued Interest: When you purchase a security on the secondary market, there may be interest that has accrued that you are entitled to at the next coupon payment date. Of course, this interest 'belongs' to the seller, so the purchase price recognises this accrued interest in the purchase price.
Bond: A generic term for Non Term Deposit securities that are traded regularly on the money markets. These can include Bank Bonds, Corporate Bonds, Government Bonds, Local Authority Bonds.
Compounding: On some Term Deposits, you have the option of 'compounding' your interest. Simply, this means that you are paid interest on the interest that you have already received. If you don't need the income to spend, then compounding is generally the best option. Please note that it is important to understand that some returns that pay 'interest on maturity' may not be as good as if you take a lower interest rate and 'compound' the interest. Most 'non Term Deposit securities' do not offer the option to 'compound'.
Coupon: This is the contractual interest payment that the issuer will pay to you. This is set at issue date and is regularly paid until maturity (unless the issuer defaults). This is different to the 'yield to maturity' if you are purchasing on the secondary market. For some securities where the interest can be 'reset', this coupon will change at each 'reset date'.
Coupon Frequency: The number of times a coupon is paid each year. Government Stock pays 2x a year (usually 6 months after issue date and 6 months later.) Some investments pay 4x a year (interest paid each quarter.)
Credit Rating: There are a range of credit ratings, from NR (Not rated, where the issuer has chosen not to get a rating) to AA+ (NZ Government Stock). To understand Credit Ratings and what they mean, you need to work out who issued the rating, and then refer to their rating system. Check out this blog article for more information How do Credit Ratings work?
Duration: This is an important term in Fixed Interest Analysis. Duration is used to measure a portfolio of fixed interest securities, and fund managers adjust the 'duration' of a portfolio to reflect the economic and investment outlook and environment.
Technically this is what 'duration' is: The duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received. When an asset is considered as a function of yield, duration also measures the price sensitivity to yield, the rate of change of price with respect to yield or the percentage change in price for a parallel shift in yields
Face Value: This is the original amount that has been lent on that fixed interest security. Generally securities are issued in $5,000 or $10,000 units.
Interest payable on maturity: Some term deposit offers appear to offer a higher rate if you take the 'interest payable on maturity.' This means that the Financial Institution is not required to make payments of interest to you along the way, during the investment. It is important to compare this with the interest return you would get if you took a quarterly or monthly payment that is compounded. Often the lower 'compounding' rate will give you a higher return than interest payment upon maturity.
Maturity/Reset Date: This is when the investment 'ends'. Upon maturity as long as the issuer is 'healthy' you will get back the 'Face Value' of the investment. This might be $5,000 or $10,000. For a 'perpetual' investment, there is often no guaranteed repayment date. But the perpetual issuer may have an option to repay investors at a certain date if they wish. It is important that you understand the risks associated with Perpetual Securities.
Minimum Size: There is a minimum $ value for a purchase of a security and this usually reflects the Face Value of the security. These are usually in $5,000 and $10,000 packages.
Price Paid: When you purchase a security on the secondary market, you are likely to pay a price that is different to the 'Face Value' of the investment. This price takes into account a number of factors including how much demand there is for the investment, what the 'coupon rate' is compared to current interest rates, what the credit rating is for the investment. The price that you pay will reflect the 'yield to maturity' for that investment, where you are repaid the 'Face Value' of the investment on maturity.
Reset Date: For floating rate bonds, or perpetuals with a reset option, this is the date that the coupon rate is 're-set'.
Stockbrokers Commission: When you purchase a Fixed Interest Security, you need to do this through an authorised broker. There is a fee associated with this purchase. If you are a direct retail investor, this commission can be anywhere up to 1.5% or higher for the transaction. Fund Managers have negotiated rates that are minimal, as a result of the volume of transactions. For Moneyworks DIMs clients, these rates are around 0.40%.
Type of Security: This refers to the 'kind' of security that you are buying. There are different risks associated with the types of securities, that reflect their ranking with creditors, and how they work. Some common types of securities are:
|Type of Security||Abbreviation|
|Callable Subordinated Debt||Call Sub|
|Perpetual Callable Subordinated Debt||Tier 2|
|Perpetual Non-Cumulative Callable Subordinated Debt||Tier 1|
|Perpetual Preference Share||Perp Pref|
|Redeemable Preference Shares||RPS|
|Senior Ranking Debt||Snr|
Yield: This is the per annum pre tax return that you will actually receive for the remaining life of the bond (if you hold to maturity) when you purchase a security on the secondary market.
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By Carey Church