Section 2.1: Fixed Income Securities — Bonds and Their Risks

Estimated study time: 50 minutes

Content:

Fixed income securities are a core component of most client portfolios, particularly for income-seeking or risk-averse clients. Series 66 candidates must understand bond mechanics, risks, and how fixed income fits into an overall investment strategy.

Corporate bonds are debt obligations issued by corporations to fund operations, acquisitions, or capital expenditures. They pay semiannual coupon interest and return principal at maturity. The yield on a corporate bond exceeds that of a comparable Treasury (the "credit spread") to compensate investors for default risk. The credit spread widens during recessions (when default risk rises) and narrows during economic expansions.

Government agency bonds include securities issued by government-sponsored enterprises (GSEs) like Fannie Mae (FNMA), Freddie Mac (FHLMC), and Ginnie Mae (GNMA). Ginnie Mae securities are backed by the "full faith and credit" of the U.S. government; Fannie Mae and Freddie Mac bonds carry an "implied" (not explicit) government guarantee. Agency bonds typically yield slightly more than Treasuries to compensate for this distinction.

Bond yield measures are essential for the Series 66:

• Current yield = Annual coupon / Current market price. Simplest measure; ignores time to maturity.
• Yield to maturity (YTM) = The total return anticipated if the bond is held to maturity, accounting for price discount/premium amortization. This is the most comprehensive yield measure.
• Yield to call (YTC) = The return if the bond is called at the first call date. For callable bonds trading above par, YTC may be more relevant than YTM since issuers are likely to call when they can refinance at lower rates.

When a bond is purchased at a premium (above par), its YTM is less than its coupon rate. When purchased at a discount (below par), its YTM is greater than its coupon rate. At par, YTM equals the coupon rate. This relationship underlies countless exam questions.

Duration quantifies interest rate risk. Macaulay duration is the weighted average time to receive the bond's cash flows. Modified duration converts this to a direct estimate of price sensitivity: a bond with modified duration of 7 will fall approximately 7% in price for each 1% rise in interest rates. Zero-coupon bonds have the highest duration (equal to their maturity) because all cash flow is received at the end.

Reinvestment risk — the risk that coupon payments received will be reinvested at lower rates in the future — affects all coupon-paying bonds. Zero-coupon bonds eliminate reinvestment risk because there are no interim payments. Callable bonds have the highest reinvestment risk because they are most likely to be called exactly when rates fall and reinvestment rates are lowest.

Key Terms:

• Current yield: Annual coupon payment divided by current market price; simple but incomplete yield measure.
• Yield to maturity (YTM): Total return if bond held to maturity; accounts for coupon, price appreciation/depreciation, and time value.
• Yield to call (YTC): Return on a callable bond if called at the first call date; most relevant for premium callable bonds.
• Credit spread: The yield premium above comparable Treasuries that a corporate or agency bond must offer to compensate for additional risk.
• Premium bond: Bond priced above par; coupon rate exceeds current YTM.
• Discount bond: Bond priced below par; YTM exceeds coupon rate.
• Modified duration: Measure of a bond's price sensitivity to a 1% change in yield; expressed as a percentage change in price.
• Reinvestment risk: Risk that coupon payments will be reinvested at lower rates than the original bond's yield.
• GSE (Government-Sponsored Enterprise): Entities like Fannie Mae, Freddie Mac that issue agency securities; not explicitly backed by full faith and credit.

Quiz Questions:

Q1. A callable bond has a coupon of 6% and is currently priced at 105 (above par). An investor considering this bond for an income-oriented client should be most concerned about:

A) Default risk, since the issuer is financially stressed B) Reinvestment risk, since the bond is likely to be called when rates fall C) Currency risk, since the bond is denominated in a foreign currency D) Inflation risk, since the coupon rate is fixed

Answer: B — A callable bond priced at a premium means the market believes the issuer will eventually call it. Callable bonds are called when interest rates fall, forcing investors to reinvest at lower yields — this is reinvestment risk. A bond priced at a premium (above par) is priced that way precisely because its coupon rate is attractive relative to current rates, making a call more likely, not less.

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Q2. Bond A has a modified duration of 3. Bond B has a modified duration of 9. If interest rates rise by 1%, which statement is correct?

A) Bond A's price will fall more than Bond B's B) Bond B's price will rise by approximately 9% C) Bond B's price will fall by approximately 9% while Bond A's price will fall by approximately 3% D) Both bonds will fall by the same amount because they have the same credit quality

Answer: C — Modified duration estimates price change per 1% change in yield. Bond A falls ~3% and Bond B falls ~9% when rates rise 1%. Duration measures both the magnitude and direction of price sensitivity; longer duration means greater rate risk.

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