Bond Glossary

What is an Inverted Yield Curve?

An inverted yield curve refers to a phenomena in the bond markets where bond securities with shorter maturities actually have higher yields than bonds with longer term maturities with similar credit qualities.

Interest Rate Swap - Overview

An interest rate swap is a contractual agreement to exchange periodic interest payments. In most cases one of the rates is fixed and the other is a variable rate whose performance is matched against the prime rate. Interest rate swaps are normally longer in their terms, generally for a period of one year or more.

What is Inflation?

The measure of price increases within a set of goods and services over a period of time is known as inflation.

What is the GDP?

The gross domestic product, or GDP, is the total value of a nations goods and services produced within a preset period of time.  Usually, GDP is measured on a calendar year basis.  More precisely, GDP can be calculated by adding up the following components:  consumption, investment, government spending, and net exports, or the spread

Overview of the Federal Fund Rate

What are Federal Funds?

All commercial and thrift banks are required to keep a certain percentage of deposits, as cash, at their district Federal Reserve Bank.  This reserve is known as federal funds and is a safety measure put in place to keep stability in the banking system in the case of a financial crisis where there is a run at the banks.  Federal funds are non-interest bearing and usually average 10% of the banks deposits over the past 14 days.  Banks, usually smaller thrifts, who are not able to meet the reserve requirements look to other institutions which have excess reserves for a loan at a negotiated interest rate. 

What is an Economic Recession?

In economics, the term recession is generally used to describe a situation in which a country's GDP, or gross domestic product, sustains a negative growth factor for at least 2 consecutive quarters.  I say generally because recession can be defined differently by different economists.  Just as there is an agency to define the measure of inflation; the official agency in charge of declaring that the economy is in a state of recession is the National Bureau of Economic Research (NBER).  NBER's definition of recession is a bit more vague than the standard one that was described above; they define recession as a "significant decline in economic activity lasting more than a few months".  For this reason, the official designation of recession may not come until after we are in a recession for six months or even longer.

What is a Discount Rate?

The term discount rate can have one of two meanings.  The discount rate can be used to describe the interest rate that an eligible depository institution can borrow funds from the federal reserve.  The federal reserve sets two interest rates; federal funds discount rate which we just discussed and the federal funds rate.   

In calculating the value of a bond, discount rate may also refer to the interest rate that is used to calculate the present value of future cash flows.  The formula is: 

Future Value of Cash Flow / (1 + discount factor/number of coupon payments per year) ^ n

n = number of coupon periods in the future.

For example:  Assuming semi-annual coupon payments at 5% and a coupon of $100; the present value of the coupon paid 1 year from now would be calculated as such:

$100 / (1 + .05/2) ^ 2 = $95.18

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What is a Credit Rating?

A credit rating defines the financial strength of a borrower and helps the investor determine the likelihood that the bond issuer will pay coupon payments in a timely fashion and more importantly the initial investment at maturity.  There are two major credit rating agencies; they are Standard & Poors and Moody.  They both conduct extensive research on the bond issuer before assigning a credit rating to them.  The bond rating will affect the interest rate that the issuer will need to pay investors; the stronger the credit rating, the lower the interest expense for the issuer. 

What is the CPI?

The consumer price index, aka. CPI, is the key gauge for inflation; it measures price increases and decreases on common group of consumer goods and services on a monthly basis.  The CPI is calculated by taking a weighted average of price change for a pre-determined group of goods.  The goods are weighted in order of their importance.  The consumer price index is very similar, but not to be confused with, to the cost of living index which allows for substitutions of the items as prices move higher or lower.