A client holds a convertible bond trading at $1,160. The stock is at $55. She asks if she should convert. If you do the math wrong, you cost her $60. Three categories of bonds show up across the Series 7, corporate, municipal, and government. Each has its own rules for security, tax treatment, pricing, and risk.
Corporate bonds rank by their claim on assets in liquidation. This hierarchy matters for suitability and credit analysis.
Secured bonds have collateral backing them. Mortgage bonds are secured by real property, land and buildings. Equipment trust certificates are secured by specific equipment like aircraft or railcars. Collateral trust bonds are secured by financial assets such as stocks or bonds of a subsidiary.
Unsecured bonds rely on the issuer's general creditworthiness. A debenture has no specific collateral. A subordinated debenture sits below all other debt, every other bondholder gets paid first in liquidation.
KEY: The liquidation priority runs: secured debt (mortgage bonds, equipment trust) > debentures > subordinated debentures > preferred stock > common stock.
Common mistakes
- Confusing net and gross revenue pledges. Under a net revenue pledge, O&M expenses get paid first. The exam asks what has first priority, the trap is choosing "debt service." Under a gross pledge, debt service is first. Remember: "net" means bondholders get the net (what remains after expenses).
- Using the wrong TEY formula. Students sometimes multiply the muni yield by (1 - tax rate) instead of dividing. That gives you the after-tax yield of a taxable bond, not the TEY. If you get 2.73% (which is 4.20% x 0.65), you used the formula backwards.
- Forgetting phantom income on zeros. The exam offers "tax-deferred until maturity" as a choice for zero-coupon bonds. Wrong. OID accretion is taxed annually on corporate and Treasury zeros. The only exception: muni zero-coupon bonds, where the accretion is tax-free.
Bottom line
- Corporate bond hierarchy: secured (mortgage, equipment trust) > unsecured (debenture) > subordinated debenture; the Trust Indenture Act of 1939 forces a qualified indenture and an independent trustee once an issuer sells more than $50 million of debt in twelve months...
- Conversion ratio = par / conversion price. Parity = conversion ratio x stock price. Convert only when parity exceeds the bond or call price.
- GO bonds rely on taxing power and need voter approval; revenue bonds rely on project income and do not. Net pledge pays O&M first, gross pledge pays debt service first.
- TEY = tax-free yield / (1 - tax rate). A higher bracket means a higher TEY and a bigger muni advantage.
Exam shortcut
When the question says "full faith and credit," think GO bonds or GNMA, those are the only two. Revenue bonds and FNMA/FHLMC never have this language. For TEY, remember: divide, do not multiply. TEY is always bigger than the muni yield. If your answer is smaller, you used the formula backwards. Yield relationship on a premium bond: N > C > Y (nominal > current > YTM).
The full lesson (about 4,738 words, 32 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- C11
- C12
- C13
- C14
- C15
- C16
- C17
- C18
- C19
- C20
- C21
- C22
- C23
- C24
- C25
- C26
- C27
- C28
- C29
- C30
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