A bond's promise is fixed on the day it is issued, but the value of that promise changes every day. Interest rates, credit quality and time to maturity drive the price. Most debt questions on the exam test one of those three forces.
When you buy a bond, you lend money to the issuer. In return, the issuer promises regular interest and repayment at maturity. Three terms describe that promise:
- Par value: The amount repaid at maturity, usually $1,000 per corporate or municipal bond. It is also called face value or principal.
- Coupon rate: The fixed annual interest rate, stated as a percentage of par and set at issue.
- Interest income: The dollars you receive, equal to par times the coupon rate. Most notes and bonds pay it in two semiannual installments.
A 5% bond pays $50 of interest income a year as two $25 payments, whether you paid $900 or $1,100 for it. Bond prices are quoted as a percentage of par value.
Common mistakes
- Listing the wrong bill terms. Bills run 4, 6, 8, 13, 17, 26 and 52 weeks. An answer that omits the 6-week bill or offers a 2-year bill is wrong. So is "bills are always discounted," since a zero-rate auction prices bills at par.
- Dividing by par for current yield. A 5% bond priced at $1,060 has a current yield of $50 ÷ $1,060 = 4.72%, not 5%. Only the coupon is figured on par.
- Expecting calls when rates rise. Issuers call after interest rates fall. Rising rates make a call less likely and push a municipal confirmation toward YTM.
Bottom line
- Treasury bills run 4, 6, 8, 13, 17, 26 and 52 weeks and sell at a discount or par; notes run 2, 3, 5, 7 or 10 years, bonds 20 or 30, TIPS 5, 10 or 30, and STRIPS are...
- Treasury auctions are single-price: noncompetitive bids (up to $10 million) fill first, competitive bids (up to 35% of the offering) fill from the lowest yield up, and every winner gets the high yield.
- Among agency securities, only Ginnie Mae carries U.S. full faith and credit; Fannie Mae and Freddie Mac securities are not U.S. obligations; MBS and ABS carry prepayment and extension risk.
- Mortgage bonds, equipment trust certificates and collateral trust bonds are secured; debentures are unsecured, and subordinated debentures rank behind other unsecured debt.
Exam shortcut
Run every bond stem through two questions. First, is the price above or below 100? Above means premium, so YTC is the smallest yield and the number a callable municipal confirmation shows. Below 100 flips every inequality. Second, which way did interest rates move? Falling rates mean rising prices, early calls and faster prepayments. Rising rates hurt long and zero-coupon bonds the most.
The full lesson (about 5,223 words, 35 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- B6
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