Estimated study time: 45 minutes
Content:
A bond is a debt security representing a loan from the investor (bondholder) to the issuer. In exchange for the principal (face value or par value), the issuer promises to make periodic interest payments (coupons) and to repay the principal at maturity. Understanding bond indentures — the legal contract governing a bond — and the key structural features of bonds is foundational to fixed income analysis. The indenture specifies the covenants, which may be affirmative (the issuer must do certain things, like maintain insurance or file financial statements) or negative (the issuer must refrain from certain actions, like incurring additional debt above a threshold or paying dividends above a specified amount). Covenants protect bondholders from actions that would reduce the security of their investment.
Bond features vary along several dimensions. Coupon structure: fixed-rate bonds pay a constant coupon; floating-rate notes (FRNs) pay a variable coupon tied to a reference rate (e.g., SOFR + spread); zero-coupon bonds pay no coupon but are issued at a discount to par and mature at par. Maturity: short-term bonds (typically <2 years) have low interest rate sensitivity; long-term bonds (>10 years) have high sensitivity. Seniority: secured bonds have claims on specific collateral; senior unsecured bonds have general claims on assets; subordinated bonds have residual claims after senior creditors are satisfied. In bankruptcy, the absolute priority rule dictates the order of repayment: secured creditors first, then senior unsecured, then subordinated, then preferred equity, then common equity.
Embedded options in bonds significantly affect their pricing and behavior. Callable bonds give the issuer the right to redeem the bond before maturity at a specified call price — issuers call bonds when rates fall, allowing refinancing at lower costs. Because the call option benefits the issuer at the bondholder's expense, callable bonds offer higher yields (lower prices) than otherwise equivalent non-callable bonds. Putable bonds give the investor the right to sell the bond back to the issuer at a specified price — beneficial when rates rise. Convertible bonds give the holder the right to exchange the bond for a specified number of the issuer's common shares, providing equity upside. The call, put, and conversion features are valuable options; their pricing requires option-adjusted models rather than standard discounted cash flow.
Government bonds, corporate bonds, municipal bonds, and securitized products represent the major segments of the fixed income market. Government bonds (Treasuries in the U.S., Gilts in the U.K., Bunds in Germany) are considered credit-risk-free in their local currency and serve as the benchmark yield curve. Corporate bonds carry credit risk (default risk) and must offer a yield spread above Treasuries to compensate. The credit spread reflects both the probability of default and the expected recovery rate given default. Municipal bonds (munis) in the U.S. are issued by state and local governments; their interest is typically exempt from federal (and often state) income taxes, making their after-tax yield competitive for high-income investors even with lower pre-tax yields. Agency bonds (Fannie Mae, Freddie Mac) carry implicit government backing and have low credit risk.
Key Terms:
Quiz Questions:
Q1. A callable bond is most likely to be called by the issuer when:
A) Interest rates have risen significantly above the coupon rate B) Interest rates have fallen significantly below the coupon rate C) The bond is trading at a significant discount to par D) The company's credit rating has been downgraded
Answer: B — Issuers call bonds when prevailing interest rates have fallen below the bond's coupon rate, allowing them to refinance the debt at a lower cost. For example, if a company issued bonds at 6% and current rates are 4%, it can call the old bonds and issue new ones at 4%, saving 2% annually on its interest costs. The call option benefits the issuer — bondholders face reinvestment risk because they receive their principal back when rates are low and must reinvest at the unfavorable lower rates.
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Q2. In a corporate bankruptcy, assets are distributed in the following order of claims. Which sequence reflects the absolute priority rule?
A) Common equity → Preferred equity → Unsecured creditors → Secured creditors B) Secured creditors → Senior unsecured creditors → Subordinated creditors → Preferred equity → Common equity C) Common equity → Subordinated creditors → Senior unsecured → Secured creditors D) All creditors share equally, then equity holders receive the remainder
Answer: B — The absolute priority rule (codified in bankruptcy law) requires that more senior claims be fully satisfied before junior claims receive anything. Secured creditors (backed by collateral) are first, followed by senior unsecured creditors, then subordinated creditors, then preferred equity, and finally common equity — who often receive nothing in liquidation. Understanding this hierarchy is essential for credit analysis and for pricing the yields on securities at different seniority levels.
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Q3. A zero-coupon bond with a face value of $1,000 matures in 5 years. If the required yield is 6%, what is the bond's price today?
A) $747.26 B) $1,000.00 C) $700.00 D) $772.19
Answer: A — Price = FV / (1 + r)^N = $1,000 / (1.06)^5 = $1,000 / 1.3382 = $747.26. Zero-coupon bonds are issued at a discount and accrete toward par over time. The entire return comes from price appreciation rather than periodic coupon payments. Zero-coupon bonds have very high interest rate sensitivity (long effective duration) because all cash flows occur at maturity.
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Q4. A floating-rate note (FRN) pays a coupon of SOFR + 150 basis points, reset quarterly. If SOFR rises from 4.5% to 5.5%, what happens to the FRN's coupon and price?
A) The coupon rises from 6.0% to 7.0%; price remains approximately unchanged because the coupon adjusts to reflect new rates B) The coupon stays fixed and the price falls C) The coupon rises and the price rises significantly D) The FRN converts to a fixed-rate bond once SOFR exceeds 5%
Answer: A — FRNs reset their coupons periodically to reflect current market interest rates. When SOFR rises 100 bps, the coupon increases from 6.0% to 7.0%, keeping the bond's yield competitive with current market rates. As a result, the price stays close to par (unlike fixed-rate bonds, which fall in price when rates rise). This is why FRNs are attractive to investors who expect rising interest rates or prefer minimal interest rate risk.
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Q5. An investor compares a taxable corporate bond yielding 6% and a municipal bond yielding 4.2%. The investor is in the 35% federal tax bracket. Which bond provides the higher after-tax yield?
A) The corporate bond with 6% pre-tax yield B) The municipal bond, which is equivalent to a taxable yield of approximately 6.46% C) They are equivalent after taxes D) The municipal bond, equivalent to a taxable yield of 4.2%
Answer: B — Tax-equivalent yield of the municipal bond = Tax-exempt yield / (1 – tax rate) = 4.2% / (1 – 0.35) = 4.2% / 0.65 = 6.46%. The muni's 4.2% tax-exempt yield is equivalent to a taxable yield of 6.46%, which exceeds the corporate bond's 6% taxable yield. For investors in high tax brackets, municipal bonds often provide superior after-tax returns despite lower nominal yields.
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