Debt Securities

Corporate Bond Types

Corporate bonds are debt instruments issued by corporations to raise capital. When an investor buys a bond, they are lending money to the issuer in exchange for periodic interest payments (coupons) and the return of principal (par value) at maturity. Corporate bonds are classified by the type and quality of their backing, which directly affects their credit risk and the interest rate the issuer must pay.

Secured Bonds

Secured bonds are backed by specific collateral, giving bondholders a claim on designated assets if the issuer defaults. The three main types of secured corporate bonds are:

Mortgage Bonds: Secured by a lien on real property (land and buildings) owned by the issuer. In the event of default, the trustee can foreclose on the property and sell it to repay bondholders. Mortgage bonds may be classified as first mortgage (senior lien) or second mortgage (junior lien). First mortgage bondholders have priority over second mortgage bondholders on the same property. Mortgage bonds are considered among the safest corporate bonds because real estate typically retains significant value.

Collateral Trust Bonds: Secured by a pledge of securities (stocks, bonds, or other financial assets) owned by the issuer, typically securities of a subsidiary. The pledged securities are held by a trustee. If the issuer defaults, the trustee can liquidate the securities to pay bondholders. The value of the collateral can fluctuate with market conditions, making these somewhat riskier than mortgage bonds.

Equipment Trust Certificates (ETCs): Secured by specific equipment or machinery, most commonly used by railroads, airlines, and shipping companies. The equipment is purchased by a trustee and leased to the issuer. The issuer makes lease payments that cover principal and interest to bondholders. The trustee retains legal title to the equipment until the bonds are fully paid. ETCs often use a serial maturity structure, with portions maturing at regular intervals. They are considered very safe because the equipment has tangible resale value and the trustee can repossess it.

Unsecured Bonds

Unsecured bonds are not backed by specific collateral. Instead, they are supported by the issuer's general creditworthiness and ability to generate revenue. The two main types are:

Debentures: Unsecured bonds backed only by the issuer's general credit and reputation. Debenture holders are general creditors with no specific claim on particular assets. Because they lack collateral, debentures are riskier than secured bonds and typically offer higher interest rates. Most corporate bonds issued by investment-grade companies are debentures, reflecting investor confidence in the company's financial strength.

Subordinated Debentures: Unsecured bonds that rank below (are subordinate to) regular debentures and all other senior debt in the event of liquidation. In bankruptcy, subordinated debenture holders are paid only after secured creditors, general creditors, and senior debenture holders have been satisfied. Because of this additional risk, subordinated debentures pay the highest interest rates among corporate bonds.

Bond Pricing: Points and Basis Points

Understanding bond pricing conventions is critical for the Series 7 exam. Corporate and government bonds are quoted differently, and you must know how to convert quotes to dollar amounts.

Corporate Bond Pricing (Points)

Corporate bonds have a par value of $1,000 and are quoted as a percentage of par. Each point equals 1% of par value, or $10. Fractions are expressed in eighths or decimals.

• A bond quoted at 98 = 98% of $1,000 = $980 (trading at a discount)
• A bond quoted at 100 = 100% of $1,000 = $1,000 (trading at par)
• A bond quoted at 103.50 = 103.5% of $1,000 = $1,035 (trading at a premium)

Basis Points

A basis point (bp) equals 1/100th of 1 percent (0.01%). There are 100 basis points in 1 percentage point. Basis points are used to express changes in yield or interest rates with precision.

• 50 basis points = 0.50%
• 100 basis points = 1.00%
• A yield moving from 4.25% to 4.75% has increased by 50 basis points

Premium vs. Discount Bonds

A bond's market price relative to par reveals important information about how its coupon rate compares to prevailing market interest rates:

• Premium bond (price > par): The coupon rate exceeds the current market yield. Investors are willing to pay more than par to receive the above-market coupon. As the bond approaches maturity, the premium amortizes toward par.
• Discount bond (price < par): The coupon rate is below the current market yield. The bond must be priced below par to make the total return competitive. The discount accretes toward par at maturity.
• Par bond (price = par): The coupon rate equals the current market yield. All yields converge at the coupon rate.

Yield Calculations

The Series 7 exam tests four different yield measures for bonds. You must understand each, know the formulas, and recognize the relationships among them.

Nominal Yield (Coupon Rate)

The nominal yield is the annual interest rate stated on the bond, also called the coupon rate. It is fixed at issuance and does not change. Nominal yield is expressed as a percentage of par value.

Formula: Nominal Yield = Annual Coupon Payment / Par Value

Example: A bond with a $1,000 par value paying $60 annually has a nominal yield of 6%.

Current Yield (CY)

The current yield measures the bond's annual income relative to its current market price. It reflects the actual income return an investor receives based on the purchase price.

Formula: Current Yield = Annual Coupon Payment / Current Market Price

Yield to Maturity (YTM)

Yield to maturity is the total annualized return an investor earns if the bond is held to maturity and all coupons are reinvested at the YTM rate. It accounts for coupon income, the time value of money, and any gain or loss from buying the bond at a discount or premium. YTM is the most comprehensive and commonly used yield measure.

Approximation Formula:

YTM (approximate) = [Annual Coupon + (Par Value - Market Price) / Years to Maturity] / [(Par Value + Market Price) / 2]

Yield to Call (YTC)

Yield to call is similar to YTM but assumes the bond is called (redeemed early by the issuer) at the earliest call date at the specified call price. YTC is relevant for callable bonds trading at a premium, where early redemption is likely because the issuer can refinance at lower rates.

Approximation Formula:

YTC (approximate) = [Annual Coupon + (Call Price - Market Price) / Years to Call] / [(Call Price + Market Price) / 2]

Bond Ratings and Credit Risk

Credit risk (default risk) is the risk that a bond issuer will fail to make timely interest or principal payments. Independent rating agencies assess this risk and assign ratings that guide investors.

Rating Agencies and Scales

The three major rating agencies are Moody's, Standard & Poor's (S&P), and Fitch. Their rating scales:

The dividing line between investment grade and speculative (junk) bonds is BBB/Baa (investment grade) versus BB/Ba (speculative). Many institutional investors and fiduciaries are restricted to investing in investment-grade bonds only.

Convertible Bonds

A convertible bond gives the bondholder the right to convert the bond into a fixed number of shares of the issuer's common stock. This conversion feature is valuable because it provides upside potential if the stock price rises while still offering the downside protection of a fixed-income instrument.

Conversion Ratio and Conversion Price

The conversion ratio is the number of common shares received upon conversion. The conversion price is the effective price per share paid through conversion.

Conversion Ratio: = Par Value / Conversion Price

Conversion Price: = Par Value / Conversion Ratio

Parity

Parity exists when the bond's market price equals its conversion value. At parity, an investor is indifferent between holding the bond and converting to stock.

Parity price of common stock: = Bond Market Price / Conversion Ratio

Parity price of bond: = Stock Price x Conversion Ratio

Because convertible bonds offer this equity conversion feature, they typically carry a lower coupon rate than comparable non-convertible bonds. Investors accept lower current income in exchange for the potential upside participation.

Forced Conversion

Many convertible bonds are also callable. If the conversion value exceeds the call price, the issuer can call the bonds, effectively forcing bondholders to convert rather than accept the below-market call price. This is known as forced conversion and is a common exam topic.

Zero-Coupon, Callable, and Puttable Bonds

Zero-Coupon Bonds

Zero-coupon bonds do not make periodic interest payments. Instead, they are issued at a deep discount from par value and mature at full par. The difference between the purchase price and par represents the investor's total return (interest income). Key characteristics:

• No reinvestment risk because there are no coupons to reinvest.
• Highest interest rate (duration) risk of any bond type because all cash flow is received at maturity.
• Phantom income (OID): Even though no cash is received until maturity, the IRS requires the annual accretion of the Original Issue Discount (OID) to be reported as taxable interest income each year. This "phantom income" is a key disadvantage for taxable investors.
• Most volatile bond type -- price swings are amplified because there are no interim cash flows to cushion the impact of interest rate changes.

Callable Bonds

A callable bond gives the issuer the right to redeem the bond before maturity, typically at a call premium above par. Key points:

• Issuers call bonds when interest rates decline, allowing them to refinance at lower rates.
• Call protection: Most callable bonds have a period (e.g., 5-10 years) during which they cannot be called.
• Call risk hurts investors because they lose the above-market coupon and must reinvest at lower prevailing rates.
• Callable bonds are priced to the WORST outcome: for premium bonds trading above the call price, use YTC (yield to call); for discount bonds, use YTM (yield to maturity).

Puttable Bonds

A puttable bond gives the bondholder the right to sell the bond back to the issuer at par on specified dates before maturity. This feature benefits the investor:

• If interest rates rise and the bond's price falls below par, the investor can put (sell back) the bond at par instead of taking a loss.
• The put feature provides downside protection and reduces interest rate risk.
• Because the put feature is valuable to investors, puttable bonds typically carry lower coupon rates than comparable non-puttable bonds.