Fixed Income Securities Basics

Fixed income securities (bonds) are debt instruments where the issuer borrows money from investors and promises to pay periodic interest and return principal at maturity. Understanding bond pricing and yields is fundamental to advising clients on fixed income investments.

What is a Bond?

A bond is essentially an IOU. When you buy a bond, you're lending money to the issuer in exchange for:

1. Periodic interest payments (usually semiannual)
2. Return of principal at maturity

Bondholders vs. Stockholders

---

Key Bond Terminology

Calculating Annual Interest

Annual Interest = Par Value × Coupon Rate

Example: A $1,000 bond with a 6% coupon pays $60 annually ($30 semiannually).

---

Bond Pricing: The Inverse Relationship

Bond prices and interest rates move in OPPOSITE directions.

Why?

When market interest rates rise, newly issued bonds offer higher coupons. Existing bonds with lower coupons become less attractive, so their prices fall to compensate buyers.

Premium, Par, and Discount

Example: A 5% coupon bond trades at a discount when market rates are 6% because investors can get better yields elsewhere.

---

Types of Bond Yields

Understanding different yield measures is crucial for the exam.

1. Nominal Yield (Coupon Rate)

The stated interest rate on the bond.

Nominal Yield = Annual Coupon / Par Value

2. Current Yield

The annual income relative to the current market price.

Current Yield = Annual Coupon / Current Market Price

Example: A $1,000 par bond with 6% coupon trading at $900:

• Current Yield = $60 / $900 = 6.67%

3. Yield to Maturity (YTM)

The total return if the bond is held to maturity, accounting for:

• All coupon payments
• Any gain or loss from buying at a premium or discount

YTM is considered the most comprehensive yield measure.

4. Yield to Call (YTC)

For callable bonds, the return if called at the earliest call date.

---

Yield Relationships

For Premium Bonds (Price > Par)

The investor pays more than par but receives back only par at maturity (loss).

Yields from LOWEST to HIGHEST: YTC < YTM < Current Yield < Nominal Yield

For Discount Bonds (Price < Par)

The investor pays less than par but receives par at maturity (gain).

Yields from LOWEST to HIGHEST: Nominal Yield < Current Yield < YTM < YTC

Memory Trick

• Premium bonds: Investors "lose" at maturity, so true yields (YTM, YTC) are lower
• Discount bonds: Investors "gain" at maturity, so true yields are higher

---

Bond Quotations

Bonds are typically quoted as a percentage of par value.

---

Exam Tip: The inverse relationship between bond prices and interest rates is heavily tested. Also memorize the yield order: For PREMIUM bonds, YTC < YTM < CY < Nominal. For DISCOUNT bonds, it's reversed.