Overview
Debt securities represent loans made by investors to issuers (corporations, governments, municipalities) in exchange for periodic interest payments and the return of principal at maturity. Understanding the relationships between price, yield, risk, and structure is fundamental to the Series 7 exam. This guide covers bond fundamentals, yield calculations, government and municipal securities, corporate bonds, and risk analysis.
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Bond Fundamentals
Core Concepts
The foundation of debt securities rests on a few critical relationships that appear throughout the exam.
• Par Value (Face Value): The standard par value of a corporate bond is $1,000, representing the principal the issuer promises to repay at maturity
• Coupon Rate (Nominal Yield): The stated annual interest rate, fixed at issuance and never changes
- Annual Interest Payment = Coupon Rate × Par Value
- Example: 6% × $1,000 = $60/year (paid as $30 every 6 months)
• The Inverse Price-Yield Relationship: Bond prices and yields move in opposite directions
- Rates rise → Bond prices fall
- Rates fall → Bond prices rise
Premium vs. Discount Bonds
| Condition | Price vs. Par | Yield Relationship |
|-----------|--------------|-------------------|
| Premium Bond | Price > $1,000 | Coupon Rate > Current Yield > YTM |
| Par Bond | Price = $1,000 | Coupon Rate = Current Yield = YTM |
| Discount Bond | Price < $1,000 | Coupon Rate < Current Yield < YTM |
> Memory Tip: For premium bonds, think "you paid more, so you earn less." For discount bonds, "you paid less, so you earn more."
Accrued Interest
• Definition: Interest earned by the seller from the last coupon payment date up to (but not including) the settlement date
• Who pays it: The buyer pays the seller accrued interest at settlement
• The buyer then receives the full next coupon payment, effectively recovering what they paid
Special Bond Structures
• Zero-Coupon Bond: Pays no periodic interest; issued at a deep discount from par; return comes from the difference between purchase price and par value at maturity
• Callable Bond: Gives the issuer the right to redeem the bond before maturity at a specified call price; creates reinvestment risk for investors
Key Terms
• Par Value – Principal amount repaid at maturity ($1,000 standard)
• Coupon Rate – Fixed annual interest rate stated on the bond
• Call Price – Price at which issuer can redeem a callable bond early
• Reinvestment Risk – Risk of having to reinvest proceeds at lower rates
• Accrued Interest – Interest owed to the seller at settlement
Watch Out For
• The coupon rate never changes — only the yield changes with market price
• Callable bonds are called when rates fall (bad for investors who must reinvest at lower rates)
• Don't confuse the buyer paying accrued interest vs. the seller receiving it — both are true
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Yield & Pricing
Types of Yield
| Yield Type | Formula / Definition | When to Use |
|------------|---------------------|-------------|
| Nominal Yield | = Coupon Rate; fixed at issuance | Never changes |
| Current Yield | Annual Interest ÷ Current Market Price | Quick snapshot of income return |
| Yield to Maturity (YTM) | Total annualized return if held to maturity | Most comprehensive measure |
| Yield to Call (YTC) | Annualized return assuming called at first call date | Most relevant for premium bonds |
Calculating Current Yield
Current Yield = Annual Interest ÷ Current Market Price
• Example: $60 annual coupon ÷ $900 market price = 6.67% current yield
YTM Key Assumptions
1. The bond is held to maturity
2. All coupon payments are reinvested at the same YTM rate
Bond Price Quotations
| Security Type | Quoted As | Example |
|--------------|-----------|---------|
| Corporate Bonds | % of par value | Quote of "95" = $950 per $1,000 |
| Treasury Notes/Bonds | 32nds of par | Quote of "99-16" = 99 and 16/32% = $995.00 |
| T-Bills | Discount basis | Quoted on yield/discount, not price |
Basis Points
• 1 basis point = 0.01% (one one-hundredth of one percent)
• 100 basis points = 1.00%
• Example: A yield moving from 5.00% to 5.25% increased by 25 basis points
Key Terms
• Current Yield – Annual income divided by current price
• YTM – Total return assuming bond held to maturity with coupons reinvested
• YTC – Total return assuming bond called at first call date
• Basis Point – 0.01%; the standard unit for measuring yield changes
• Nominal Yield – The coupon rate; fixed at issuance
Watch Out For
• YTM is not the same as current yield — YTM accounts for price appreciation/depreciation to par
• A quote of "95" for a corporate bond is $950, not $95
• Treasury quotes in 32nds frequently appear on the exam — practice the conversion
• YTC is most relevant when a bond trades at a premium (issuer likely to call)
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Government & Municipal Securities
U.S. Treasury Securities
| Security | Maturity | Interest Payment | Tax Treatment |
|----------|----------|-----------------|---------------|
| T-Bills | ≤ 1 year | Issued at discount (no coupon) | Federal: Yes; State/Local: Exempt |
| T-Notes | 2–10 years | Semiannual coupon | Federal: Yes; State/Local: Exempt |
| T-Bonds | 10–30 years | Semiannual coupon | Federal: Yes; State/Local: Exempt |
| TIPS | Variable | Inflation-adjusted | Federal: Yes; State/Local: Exempt |
TIPS (Treasury Inflation-Protected Securities)
• Principal is adjusted semiannually based on changes in the CPI (Consumer Price Index)
• Coupon rate is fixed, but the dollar amount of interest rises or falls as the inflation-adjusted principal changes
• Protect investors from inflation risk
Municipal Securities
#### General Tax Treatment
• Interest is exempt from federal income tax
• Typically exempt from state and local taxes in the state of issuance
• Most attractive to investors in high tax brackets
#### Types of Municipal Bonds
| Type | Backed By | Security Level |
|------|-----------|---------------|
| General Obligation (GO) | Full faith, credit, and taxing power of the municipality | Generally considered safer |
| Revenue Bond | Income from a specific project (toll road, water system, airport) | Only as safe as the project's revenue |
> Key Distinction: GO bonds are backed by the government's ability to tax. Revenue bonds depend entirely on the project generating sufficient revenue — no project revenue means no bond payment.
Tax Equivalent Yield (TEY)
TEY = Municipal Yield ÷ (1 − Tax Rate)
• Purpose: Compares the after-tax return of a tax-exempt municipal bond to a taxable bond
• Example: A 4% muni yield for an investor in the 30% tax bracket:
- TEY = 4% ÷ (1 − 0.30) = 4% ÷ 0.70 = 5.71%
- This investor needs a taxable bond yielding more than 5.71% to beat the muni
Key Terms
• T-Bill – Treasury security with maturity ≤ 1 year; no coupon
• TIPS – Inflation-protected Treasury; principal adjusted by CPI
• GO Bond – Municipal bond backed by taxing authority
• Revenue Bond – Municipal bond backed by project income
• Tax Equivalent Yield – Formula to compare muni yield to taxable yield
Watch Out For
• Treasury interest is exempt from state/local taxes but NOT from federal taxes
• Municipal interest is exempt from federal taxes — opposite of Treasuries
• Revenue bonds are not backed by taxing power — they can default if the project fails
• TEY formula: don't forget to subtract the tax rate from 1
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Corporate Bonds
Types of Corporate Bonds by Security
| Bond Type | Secured? | Backed By |
|-----------|----------|-----------|
| Mortgage Bond | Yes — Senior | Specific real property or physical assets |
| Debenture | No | Issuer's general creditworthiness only |
| Subordinated Debenture | No | General credit; junior to regular debentures |
| Convertible Bond | Varies | Can be converted to common stock |
Priority of Claims in Bankruptcy (Highest to Lowest)
1. Secured Creditors (mortgage bondholders) — paid first
2. Unsecured Creditors / Debenture Holders
3. Subordinated Debenture Holders
4. Preferred Stockholders
5. Common Stockholders — paid last (if anything remains)
> Memory Device: "Secured, Unsecured, Sub, Preferred, Common" — think of it as a waterfall flowing from top to bottom.
Convertible Bonds
• Can be exchanged by the holder for a specified number of common stock shares
• Offers fixed income of a bond + growth potential of equity
• Conversion Ratio = Par Value ÷ Conversion Price
- Example: $1,000 ÷ $25 = 40 shares
• Generally carry lower coupon rates because the conversion feature has value
Sinking Fund Provision
• Definition: Requires the issuer to set aside money periodically to retire a portion of the bond issue before maturity
• Benefit to investors: Reduces credit risk by ensuring orderly debt repayment
• Benefit to issuer: Avoids a large lump-sum repayment at maturity
Key Terms
• Debenture – Unsecured corporate bond
• Mortgage Bond – Bond secured by real property
• Subordinated Debenture – Unsecured bond with junior claim status
• Convertible Bond – Bond exchangeable for common stock shares
• Conversion Ratio – Number of shares received upon conversion
• Sinking Fund – Provision requiring periodic debt retirement
• Bond Indenture – Legal contract between issuer and bondholders
Watch Out For
• Debentures are unsecured — do not confuse with mortgage bonds
• Conversion ratio uses par value ($1,000), not market price
• In bankruptcy, all debt holders are paid before any equity holders
• Convertible bonds typically have lower coupon rates due to the conversion feature's added value
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Bond Risk & Analysis
Types of Bond Risk
| Risk Type | Definition | Most Affected By |
|-----------|-----------|-----------------|
| Interest Rate Risk | Rising rates cause bond prices to fall | Long-term, low-coupon bonds |
| Credit (Default) Risk | Issuer fails to make timely payments | Lower-rated/high-yield bonds |
| Reinvestment Risk | Coupons reinvested at lower future rates | Callable bonds; high-coupon bonds |
| Inflation Risk | Rising inflation erodes real return | Fixed-rate long-term bonds |
| Call Risk | Issuer calls bond early when rates drop | Premium callable bonds |
Interest Rate Risk: Key Factors
Bonds most susceptible to interest rate risk:
• Longer maturity — price changes more with rate changes
• Lower coupon rate — less cash flow early to offset price decline
• Zero-coupon bonds have the highest interest rate risk (no coupons, longest duration)
Credit Risk & Bond Ratings
| Rating Agency | Investment Grade | Non-Investment Grade ("Junk") |
|--------------|-----------------|-------------------------------|
| S&P | AAA, AA, A, BBB | BB, B, CCC, CC, C, D |
| Moody's | Aaa, Aa, A, Baa | Ba, B, Caa, Ca, C |
• Investment grade: BBB/Baa and above — lower risk, lower yield
• Non-investment grade (junk/high-yield): BB/Ba and below — higher risk, higher yield
Duration
• Definition: Measures the weighted average time to receive a bond's cash flows; estimates price sensitivity to interest rate changes
• Higher duration = greater price volatility when rates change
• Factors that increase duration (and price sensitivity):
- Longer maturity
- Lower coupon rate
- Lower yield
• Zero-coupon bonds have the longest duration relative to their maturity
Reinvestment Risk vs. Interest Rate Risk (The Trade-Off)
| Scenario | Interest Rate Risk | Reinvestment Risk |
|----------|-------------------|-------------------|
| Rates rise | Bond prices fall (bad) | Can reinvest at higher rates (good) |
| Rates fall | Bond prices rise (good) | Must reinvest at lower rates (bad) |
> Zero-coupon bonds eliminate reinvestment risk because there are no coupon payments to reinvest — but they carry the highest interest rate risk.
Key Terms
• Interest Rate Risk – Risk bond price falls when rates rise
• Credit Risk – Risk of issuer default
• Reinvestment Risk – Risk of reinvesting at lower rates
• Duration – Measure of price sensitivity to rate changes
• Investment Grade – Rated BBB/Baa or above
• High-Yield (Junk) Bond – Rated below BBB/Baa; higher default risk
Watch Out For
• Long-term bonds have more interest rate risk than short-term bonds
• Zero-coupon bonds eliminate reinvestment risk but have the highest interest rate risk
• Don't confuse S&P and Moody's rating scales (BBB vs. Baa for investment grade cutoff)
• Higher duration = more price volatility — duration is a measure of sensitivity, not just time
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Quick Review Checklist
Use this checklist to confirm mastery before exam day:
• [ ] Inverse relationship: Bond prices fall when interest rates rise, and vice versa
• [ ] Yield hierarchy for premium bonds: Coupon > Current Yield > YTM
• [ ] Yield hierarchy for discount bonds: Coupon < Current Yield < YTM
• [ ] Current Yield formula: Annual Interest ÷ Market Price
• [ ] YTM assumes: Bond held to maturity AND coupons reinvested at YTM rate
• [ ] Corporate bond quotes: Percentage of par ("95" = $950)
• [ ] Treasury note/bond quotes: In 32nds ("99-16" = $995.00)
• [ ] T-Bill taxation: Federal YES; State/Local EXEMPT
• [ ] Municipal bond taxation: Federal EXEMPT; typically state/local EXEMPT in home state
• [ ] Tax Equivalent Yield formula: Muni Yield ÷ (1 − Tax Rate)
• [ ] GO bonds backed by taxing power; Revenue bonds backed by project income
• [ ] TIPS: Fixed coupon rate, but principal (and thus interest payments) adjust with CPI
• [ ] Bankruptcy priority: Secured → Debentures → Subordinated → Preferred → Common
• [ ] Conversion ratio: Par Value ($1,000) ÷ Conversion Price
• [ ] Sinking fund: Reduces credit risk by retiring debt periodically before maturity
• [ ] Most interest rate risk: Long-term, low-coupon bonds (highest duration)
• [ ] Reinvestment risk eliminated by: Zero-coupon bonds
• [ ] Zero-coupon bonds: No coupons; deep discount; highest interest rate risk; highest duration
• [ ] Duration: Higher duration = greater price sensitivity to rate changes
• [ ] Investment grade cutoff: BBB (S&P) / Baa