The most fundamental rule of bond markets: interest rates and bond prices move in opposite directions.
When market interest rates rise, existing bonds with lower fixed coupons become less attractive, so their prices fall. When rates fall, existing bonds with higher coupons become more valuable, so their prices rise.
Analogy: Imagine you own a bond paying $60/year (6% coupon on $1,000 par). New bonds now pay $80/year (8%). Nobody will pay full price for yours — they will demand a discount to make up the difference. Your bond's price must fall until its effective yield matches the 8% market rate.
Duration measures a bond's price sensitivity to rate changes. Longer maturity and lower coupon = higher duration = greater price volatility for a given rate move.
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1. Nominal Yield (Coupon Rate): The stated annual interest as a percentage of par. A 6% bond pays $60/year on $1,000 par regardless of market price. Fixed for the life of the bond.
2. Current Yield (CY): Annual interest / Current market price.
3. Yield to Maturity (YTM): The total annualized return if held to maturity, accounting for coupon income plus the gain (if bought at discount) or loss (if bought at premium) realized at maturity. YTM is the most comprehensive yield measure and the one most commonly tested.
4. Yield to Call (YTC): Like YTM but assumes the bond is called at the earliest call date. Used when the bond trades at a premium and calling is likely.
For a DISCOUNT bond (price below par — rates have risen): Coupon Rate < Current Yield < YTM
Example: 6% coupon, price $950
For a PREMIUM bond (price above par — rates have fallen): Coupon Rate > Current Yield > YTM
Example: 6% coupon, price $1,050
Memory trick: The yields always "line up" on the same side as the price. If price is below par (discount), all yields stretch upward above the coupon in ascending order: coupon < CY < YTM.
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Equipment Trust Certificates (ETCs): Used heavily by airlines, railroads, and shipping companies. The trustee holds title to the equipment (aircraft, locomotives) and leases it to the company. Investors are paid from lease payments. If the company defaults, the trustee repossesses and sells the equipment. Because industrial equipment retains value and is easily repositioned, ETCs are considered very secure.
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Subordinated Debentures rank below regular debentures (and all other senior debt) in the liquidation priority. Because of their lower standing, they must offer higher yields to attract investors. Often issued by companies that have already pledged their best assets to secured lenders.
Exam rule: Common stockholders are always last. Secured creditors are always first. Subordinated debt comes after regular unsecured debt.
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Conversion Ratio: Number of shares received per bond converted.
Conversion Price: Par value / Conversion ratio = $1,000 / 25 = $40 per share (the effective price paid for stock upon conversion).
Parity Price: The stock price at which conversion is economically neutral. If the bond trades at $1,100, parity stock price = $1,100 / 25 = $44. If the stock trades above $44, conversion is profitable.
Forced Conversion: When the stock price rises well above the conversion price, issuers may call the bond, forcing investors to either convert or accept call price (usually at a slight premium to par). Since conversion yields more value, investors typically convert.
Convertibles offer lower coupon rates than comparable non-convertible bonds because the conversion feature has value — investors accept less income in exchange for equity upside potential.
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Call premium: The amount above par paid to bondholders when a bond is called. Example: a bond called at 103 pays $1,030 per $1,000 face — the $30 is the call premium.
Call protection period: A defined window (often 5-10 years from issuance) during which the issuer cannot call the bond. Protects investors from immediate redemption.
Why issuers call bonds: When interest rates fall, the issuer can refund (replace) high-coupon debt with new lower-coupon bonds, saving interest costs — just as a homeowner refinances a mortgage when rates drop.
Investor risk: Reinvestment risk — proceeds received from a called bond must be reinvested at lower prevailing rates. This is why YTC (yield to call) is the more relevant metric for premium bonds in declining rate environments.
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| Rating Category | Moody's | S&P / Fitch | |---|---|---| | Highest quality | Aaa | AAA | | High quality | Aa | AA | | Upper medium | A | A | | Lower medium | Baa | BBB | | Investment grade cutoff | Baa | BBB | | Speculative / Junk | Ba, B | BB, B | | Highly speculative | Caa | CCC | | Default | Ca/C | CC/D |
Investment grade: Baa/BBB and above — suitable for institutional investors, pension funds, insurance companies. High yield (junk): Ba/BB and below — higher default risk, higher yield premium required.
Note: Moody's uses a lowercase "a" modifier (e.g., Baa) while S&P/Fitch use uppercase letters only (BBB). This is a common exam trap.
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The Trust Indenture Act of 1939 requires that corporate bonds with a face value over $5 million sold interstate must have a formal indenture with a qualified trustee.
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Quiz Questions:
Q1. A corporate bond has a 7% coupon and is currently trading at $1,100 (a premium). Which of the following correctly ranks the yield measures from highest to lowest?
A) YTM > Current Yield > Coupon Rate B) Coupon Rate > Current Yield > YTM C) Current Yield > Coupon Rate > YTM D) Coupon Rate = Current Yield = YTM
Answer: B — For a premium bond (price above par), the yield hierarchy is: Coupon > CY > YTM. The coupon is fixed at 7%. CY = $70 / $1,100 = 6.36%, which is below the coupon. YTM is even lower because it reflects the $100 loss at maturity (bond bought at $1,100 redeems at $1,000). Answer A and C describe discount bond behavior. D is only true for par-priced bonds.
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Q2. An investor holds a convertible bond with a $1,000 par value and a conversion ratio of 40. If the bond is currently trading at $1,200, what is the parity price of the stock?
A) $25.00 B) $30.00 C) $40.00 D) $48.00
Answer: B — Parity price = Bond market price / Conversion ratio = $1,200 / 40 = $30.00. At this stock price, converting yields 40 x $30 = $1,200 in stock, exactly matching the bond's market value. A ($25) uses par value ($1,000 / 40 = $25, which is the conversion price, not parity price). C and D are incorrect calculations.
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Q3. In a corporate liquidation, which creditor class is paid FIRST?
A) Common stockholders B) Subordinated debenture holders C) Secured mortgage bondholders D) Preferred stockholders
Answer: C — Secured mortgage bondholders hold a lien on specific assets and are paid first from the proceeds of those assets. The order is: secured creditors, then general/unsecured creditors, then subordinated debtholders, then preferred stockholders, then common stockholders. Common stockholders (A) are always last. Preferred (D) and subordinated debt (B) rank well below secured debt.
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Q4. A corporation issues bonds with a call provision. Interest rates subsequently fall significantly. Which of the following is MOST likely to occur?
A) The bonds will trade at a discount as investors sell them B) The corporation will call the bonds and refinance at lower rates C) The trust indenture will be renegotiated to lower the coupon D) The bonds will be converted to common stock automatically
Answer: B — When rates fall, issuers benefit by calling outstanding high-coupon bonds and issuing new ones at lower rates — essentially refinancing. This is the primary call risk for investors. A is incorrect because falling rates cause bond prices to rise, not fall. C is wrong — trust indentures cannot be unilaterally renegotiated to change coupon rates. D describes convertible bonds, which are a separate feature unrelated to call provisions.
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Q5. Which of the following bond types ranks LOWEST in a corporate liquidation?
A) First mortgage bond B) Debenture C) Subordinated debenture D) Equipment trust certificate
Answer: C — Subordinated debentures rank below all other debt, including regular (unsubordinated) debentures. Equipment trust certificates (D) and first mortgage bonds (A) are both secured and rank highest. Regular debentures (B) are unsecured but rank above subordinated debt. The word "subordinated" literally means "ranked below" in the capital structure.