Bond Fundamentals
Bonds are debt securities that represent loans from investors to issuers. Understanding bond fundamentals is critical for Series 7 representatives, as debt securities comprise a significant portion of the exam and client portfolios.
What is a Bond?
A bond is a debt instrument where the issuer borrows money from investors and promises to repay the principal (face value) at maturity while making periodic interest payments. When you purchase a bond, you become a creditor of the issuer—not an owner like with stock.
Key parties in a bond transaction:
- Issuer: The borrower (corporation, government, municipality)
- Bondholder: The lender/investor who receives interest and principal
- Trustee: Third party that protects bondholder interests
Essential Bond Terms
Par Value (Face Value)
Par value is the amount the issuer will repay at maturity. For corporate and municipal bonds, par value is typically $1,000 per bond. This is also called face value or principal.
Coupon Rate (Nominal Yield)
The coupon rate is the annual interest rate stated on the bond, expressed as a percentage of par value. This rate is fixed at issuance and doesn't change.
Example: A bond with a 6% coupon and $1,000 par value pays $60 annually in interest (6% × $1,000 = $60).
Most bonds pay interest semiannually, so a 6% bond would pay $30 every six months.
Maturity
Maturity is the date when the issuer must repay the bond's par value to the bondholder.
| Term Classification | Maturity Period |
|---|---|
| Short-term | 1-3 years |
| Intermediate-term | 4-10 years |
| Long-term | More than 10 years |
Bond Pricing
Bonds trade at prices that may differ from par value based on market interest rates:
| Price | Relationship to Par | Market Rate vs. Coupon |
|---|---|---|
| Premium | Above $1,000 | Market rate < coupon rate |
| Par | $1,000 | Market rate = coupon rate |
| Discount | Below $1,000 | Market rate > coupon rate |
Key Concept: Bond prices and interest rates have an inverse relationship. When interest rates rise, bond prices fall. When rates fall, prices rise.
Bond Price Quotation
Bonds are quoted as a percentage of par value:
| Quote | Calculation | Dollar Price |
|---|---|---|
| 98 | 98% × $1,000 | $980 (discount) |
| 100 | 100% × $1,000 | $1,000 (par) |
| 103.50 | 103.5% × $1,000 | $1,035 (premium) |
Accrued Interest
Accrued interest is the interest that accumulates between coupon payment dates. When a bond trades in the secondary market, the buyer pays the seller the market price plus accrued interest.
Why? The seller held the bond and earned interest up to the sale date. The buyer will receive the full next coupon payment, so they compensate the seller for the portion they didn't earn.
Accrued Interest Formula
Accrued Interest = (Annual Interest ÷ 360 or 365) × Days Held
Day-Count Conventions
Different bond types use different day-count methods:
| Bond Type | Day-Count Convention |
|---|---|
| Corporate bonds | 30/360 (assumes 30-day months, 360-day year) |
| Municipal bonds | 30/360 |
| U.S. Treasury bonds | Actual/365 (actual days in each month) |
Example (30/360): A 6% corporate bond traded on March 15 with the last coupon paid January 1.
- Days accrued: January (30) + February (30) + March (15) = 75 days
- Accrued interest = ($60 ÷ 360) × 75 = $12.50
On the Exam
The Series 7 exam frequently tests:
- The inverse relationship between bond prices and interest rates
- Calculating accrued interest using the 30/360 convention
- Understanding premium vs. discount bonds
- Recognizing that coupon rates are fixed while market prices fluctuate
A bond with a 5% coupon is trading at 97. This bond is selling at:
A corporate bond pays 6% annual interest. The last coupon was paid on April 1, and the bond is sold on June 15. Using the 30/360 convention, what is the accrued interest?
If market interest rates decrease, what happens to outstanding bond prices?
2.2 Bond Yields and Pricing
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