Often I am asked the meaning of a certain word or term being used in the fixed-income industry. Today, I thought it valuable to provide some of the more commonly used terms in the bond markets along with their definitions.
The weighted average coupon of the bonds in a portfolio.
The weighted average time to receipt of principal payments, including scheduled paydowns and prepayments.
The market value weighted average maturity of the bonds in a portfolio.
The market weighted average yield to maturity/option of the bonds in a portfolio. If the bond is trading to the call (or put) date, the yield to call (put) date is used. If the bond is trading to the maturity date, the YTM is used.
Referred to as CapEx, this item represents the amount of money the firm is using to build its business. Part of Cash Flow from Investing, CapEx is a good measure of how quickly and aggressively, the company is growing - high levels would indicate faster growth while low to moderate levels indicate slower growth. Therein lies the paradox: reducing CapEx frees up cash to improve creditors' position, but deteriorates the growth outlook for the company.
Current coupon divided by current market price.
While it may seem straightforward and simple, there are some adjustments that need to be made in order to accurately assess a company's true debt load. Arguably the most important of these would be the addition of off-balance-sheet items, which can alter the debt profile significantly. Examples of such items would include operating leases or guarantees on the debt of other companies (i.e. a jointly owned venture). Essentially what is included here is long-term debt, commercial paper and any amounts drawn on bank credit facilities.
Dividing total debt by total assets essentially gives a picture of the liquidity of the company versus its obligations to creditors. As a rule of thumb, this metric is not as important as others unless the risk of bankruptcy is looming. Here, we would like to see numbers below 50 percent because, if a bankruptcy were to arise, the company may not be able to realize full value of its assets.
An option-adjusted measure of a bond's (or portfolio's) sensitivity to changes in interest rates. Calculated as the average percentage change in a bond's value (price + accrued interest) under treasury curve shifts of +/- 100 basis points. Incorporates the effect of embedded options for corporate bonds and changes in prepayments for mortgage-backed securities.
Starting with operating income and adding back depreciation (tangible assets) and amortization (intangible assets), EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. From a bondholder's perspective, it represents the company's income that is available to all investors. EBITDA is calculated as revenues minus cost of goods sold (COGS) and sales, general and administrative (SG&A) expense, plus depreciation and amortization.
Free cash flow:
Defined as operating cash flow less capital expenditures less dividends, free cash flow is a crucial item for creditors as it represents how much the company can invest in growth opportunities without borrowing. It is used for a variety of corporate purposes, including debt reduction, share repurchases, etc. Clearly, as bondholders, we keep a close eye on uses of free cash flow.
Calculated as EBITDA divided by Interest Expense, interest coverage is one of the most important ratios we observe. It represents how many times over the company (on a quarterly or annual basis) covers its interest expense with operating income. Variations will include EBIT/interest coverage, which takes depreciation and amortization out of operating income, or EBITDAR/Interest Expense + Rents, which adjusts for lease obligations.
Again, a seemingly obvious item, interest expense also requires a touch of elaboration. The most glaring cost here would be coupon payments on long-term bonds (public debt). However, interest expense, like debt, should be adjusted to reflect the expenses associated with off-balance-sheet items like lease obligations.
Also known as Macaulay's Duration, modified for a semi-annual yield expression; the weighted average time to receipt of all cash flows, including coupon payments, on a present value basis. Modified duration is equal to effective duration for bonds with no embedded options but is not a useful measure of price sensitivity for bonds with options or prepayment risk.
Constant prepayment rate (CPR):
The constant prepayment rate at which mortgage collateral is expected to prepay, expressed as an annual percentage of the remaining collateral.
The single internal rate of return which equates a bond's remaining cashflows to its market price.
Yield to worst (YTW):
The lower of yield to maturity and yield to call.
I hope you will find this useful in developing a greater understanding of the bond markets. For information, e-mail email@example.com or call 689-8700.
• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.