Characteristics of Debt Securities
Talking about Maturity, Par Value, Coupons and Accrued Interest
Debt securities have many features which determine when the borrower is to pay the money back, how much interest will be paid, and how much this will cost an investor.
Before the 1980s, investing in bonds was relatively simple. Disregarding for a moment the possibility of a borrower defaulting on his or her obligations, investors usually knew in advance how long the investment would generate interest income, how much that income was expected to be, and how much they would have to pay for the privilege.
Today, although the principle has remained the same, there are many more features of debt securities complicating the field. This is why starting out with simple terminology seems a prudent course of action for investors who are considering or already have fixed income securities in their portfolios.
Maturity
Maturity is a term often used to denote the number of years remaining before the principal borrowed amount has to be paid off. Maturity date is the date when a debt security will no longer exist since its issuer will have redeemed it by repaying the outstanding balance to each bondholder.
Par Value
The par value of a bond is the principal amount that the borrower (issuer) agrees to repay the lender (bondholder) at or by the bond’s maturity date. This value is often also called the principal value, face value, redemption value or maturity value.
Since bonds have differing par values, the generally accepted convention is to quote a bond price as a percentage of its par value. For example, a value of “100” would mean 100% of the bond's par value. It would also mean that the bond is trading at par. Another example would be a value of “94,” which would mean 94% of par value and that the bond is trading at a discount. Or, a bond can be quoted with a value of “105,” which would mean 105% of par value and the bond trading at a premium.
Coupon
The coupon rate, also referred to as the nominal rate, is the cost of borrowing that the issuer agrees to pay the bondholder each year. To calculate how much in interest is due to a bondholder each year, the coupon rate must be multiplied by the par value of the bond.
To illustrate, if a bond was issued with a coupon rate of 6%, then each $1,000 of par value of a bond will pay annual interest of $60.00. Note that most bonds in the U.S. pay interest twice a year, although there are debt securities, such as mortgage-backed securities, that practice monthly interest payments.
But not all bonds make regular periodic interest payments. For example, zero-coupon bonds do not pay interest at all, for which an investor is compensated by buying such bonds at deep discounts. There are also step-up notes, which can pay different coupon rates each year until maturity, and floating-rate debt securities that reset their coupon rates periodically and according to some reference rate, such as the prime rate.
Accrued Interest
Since coupon interest payments are not distributed every day, the interest accumulated from one coupon payment date to another accrues until it is paid to the bondholder on record. But what happens if the bond is sold in-between two coupon payment dates?
If a bondholder sells his bond in-between two coupon payment dates, the buyer owes the bondholder (seller) coupon interest that has accrued since the last coupon payment date and the sale date.
Although the buyer may appear to have had an extra cost to pay for the purchase of the bond, the accrued interest cost will be recovered in full by the time the next coupon interest payment is made. Plus, there will be an additional amount that has now accrued to the new bondholder on record from the purchase date of the bond to its next coupon payment date.
Note that the price for buying a bond that includes the accrued interest is called the full price or dirty price, as some market participants like to refer to it. The bond price without accrued interest is either called the clean price or simply the price.
There are other frequently used terms associated with accrued interest, such as a bond trading cum-coupon (or with coupon), meaning that the buyer will have to pay accrued interest to the seller. And if the buyer forgoes the next coupon payment, the bond is referred to as trading ex-coupon (or without coupon).
