Bonds, rates and government debt

ANNUITY

A contract, usually with an insurer, that converts a lump sum into a stream of payments over time - often for the remainder of the holder's life.

The pricing turns on longevity risk. The insurer is effectively betting on average lifespans, which is why annuity rates move with both interest rates and mortality assumptions.

BREAKEVEN

The point at which revenues exactly cover costs, so profit is zero. In bond markets, the inflation rate at which an inflation-linked bond and a nominal bond return the same.

The bond sense is watched as a market-implied inflation forecast, since it reflects what buyers are actually willing to pay for protection.

CONVEXITY

The curvature in a bond's price-yield relationship - how much its duration itself changes as yields move.

Positive convexity is desirable: prices rise more when yields fall than they drop when yields rise by the same amount. Duration alone understates this.

DEBENTURE

A debt instrument backed only by the issuer's general creditworthiness rather than by specific pledged collateral.

Because nothing secures it, a debenture ranks behind secured debt in a liquidation and carries a correspondingly higher yield.

DEFEASANCE

Setting aside assets, usually government securities, whose cash flows are enough to cover a debt, so the debt is treated as settled in substance.

Common in commercial real estate, where a borrower who wants to sell a property substitutes securities for the mortgage instead of paying a large prepayment penalty.

DURATION

A bond's price sensitivity to interest rates, expressed in years. A duration of 7 implies roughly a 7% price fall if yields rise one percentage point.

Not the same as maturity - it accounts for the timing of every cash flow, so a bond paying large coupons early has shorter duration than its maturity suggests.

A bond fund with a duration of 7 loses about 7% of its value when yields rise by one percentage point and gains about 7% when they fall by one. That arithmetic explains 2022, when long-dated government bonds, usually the steadier part of a portfolio, fell further than many stocks. No issuer defaulted. Interest rates rose, and bonds with long duration lost the most value.

GILT

A UK government bond.

The name comes from the gilt-edged certificates once issued. The gilt market is where UK fiscal credibility gets priced, as the 2022 selloff around an unfunded budget demonstrated.

INDENTURE

The contract governing a bond issue. It sets the interest rate, maturity, covenants, and what happens in a default.

Most disputes between a company and its bondholders turn on indenture language, and aggressive borrowers have used gaps in older indentures to move assets beyond creditors' reach.

LIBOR

The London Interbank Offered Rate, a former benchmark for the rate at which banks lend to one another, once referenced by trillions in contracts.

Discontinued after a rate-rigging scandal exposed that it rested on estimates rather than transactions. Replaced by transaction-based rates such as SOFR.

PERPETUITY

A stream of payments with no end date, and the formula used to value one: the payment divided by the discount rate.

The idea underpins valuation generally, since the terminal value in most discounted cash flow models is a perpetuity. Small changes in the assumed rate move that value a lot.

A payment of $50 a year discounted at 5% is worth $1,000. Change the rate to 4% and the value jumps to $1,250, a 25% swing from a single percentage point.

REFINANCING

Replacing existing debt with new debt, usually to lower the rate, extend maturity, or change terms.

The volume of debt maturing in a given year, the maturity wall, matters more than the total when rates have risen, since borrowers must refinance at current rates rather than the ones they originally locked.

ROLLOVER

Replacing a maturing obligation with a new one - refinancing debt, or moving a futures position into a later contract.

Rollover risk is the danger that refinancing proves unavailable or far more expensive when the obligation falls due.

SOVEREIGN

Relating to a national government - most often its debt, or the risk that a state fails to meet its obligations.

A government borrowing in its own currency can always print to repay; borrowing in a foreign currency removes that escape, and is where sovereign crises concentrate.

SPREAD

The difference between two prices or rates - between a bond's yield and a government benchmark, or between the bid and ask in a quoted market.

Credit spreads widen when investors demand more compensation for default risk, which makes them one of the more honest real-time gauges of financial stress.

SUBORDINATION

An agreement that ranks one creditor's claim behind another's, so the senior claim is paid first if the borrower fails.

Rank determines recovery. In a bankruptcy, senior secured lenders may be repaid in full while subordinated lenders recover cents on the dollar and shareholders get nothing.

TRANCHE

One slice of a security or loan, carrying its own risk, payment priority and yield.

Structured products pay tranches in order, so the senior slice absorbs losses last and yields least. The 2008 crisis turned on senior tranches of mortgage-backed deals proving far riskier than their ratings implied.

TREASURY

A debt security issued by a national government - in the United States, by the Department of the Treasury. Bills mature in a year or less, notes in two to ten years, bonds beyond that.

US Treasuries are treated as the benchmark risk-free asset, so their yields anchor the pricing of nearly everything else.

YIELD

The return an investment produces, expressed as a percentage of its price. For a bond, the income and any gain to maturity relative to what you pay for it.

Yield moves inversely to price: when a bond's price rises, the fixed payments it makes represent a smaller return for a new buyer.