Chapter 2: Debt Securities

Debt Securities

Financial instruments that represent a loan made by investors to an issuer. The investor becomes a creditor and is entitled to periodic interest payments and the return of principal at maturity. Unlike equity securities, debt securities do not represent ownership in the issuing entity.

Bond

A debt security issued by a corporation, government, or municipality to raise capital. A bond represents a loan from the investor to the issuer, who promises to pay interest at regular intervals and return the principal at maturity. Bondholders have a higher claim on assets than stockholders in the event of bankruptcy.

Fixed-Income Securities

Securities that provide investors with a predictable stream of income, typically through regular interest payments. Bonds are the primary type of fixed-income security, though preferred stock also shares similar characteristics.

Bearer Bond

A bond issued without recorded ownership, where whoever physically possesses the bond receives the interest and principal payments. Interest was collected by clipping coupons attached to the bond certificate. Bearer bonds are no longer issued due to theft and tax-evasion risks but may still trade in the secondary market.

Registered Bond

A bond for which ownership is recorded by the issuer or a transfer agent. Interest and principal payments are automatically sent to the registered owner, eliminating the need for physical coupons and reducing the risk of loss or theft.

Book-Entry Bond

A bond whose ownership is recorded electronically by a central depository rather than through physical certificates. Book-entry is the most common form of bond ownership today and allows for faster, safer, and more efficient transfers of ownership.

Par Value (Face Value / Principal)

The amount of money the bondholder will receive from the issuer at maturity. For exam purposes, bonds are assumed to have a par value of $1,000 unless stated otherwise.

Bond Quotation

The price at which a bond trades in the secondary market, typically expressed as a percentage of its par value. A quote of 100 equals $1,000, while quotes above or below 100 indicate premium or discount pricing.

Premium Bond

A bond trading above its par value. Premium bonds typically have coupon rates that are higher than prevailing market interest rates, making them more attractive to investors.

Discount Bond

A bond trading below its par value. Discount bonds generally have coupon rates that are lower than current market interest rates, causing investors to demand a lower purchase price.

Coupon

The periodic interest payment made to bondholders as compensation for lending money to the issuer. Coupon payments are calculated based on par value, not market price.

Coupon Rate (Nominal Yield)

The stated annual interest rate of a bond expressed as a percentage of par value. The coupon rate is fixed at issuance for fixed-rate bonds and does not change over the life of the bond.

Semiannual Interest Payments

Most bonds pay interest twice per year, typically every six months. Payment schedules are designated by month pairs such as January and July or March and September, and payments are usually made on the first or fifteenth day of the month.

Fixed-Rate Bond

A bond whose coupon rate remains constant throughout the life of the bond, providing predictable interest payments to investors.

Floating-Rate Bond (Adjustable-Rate or Variable-Rate Bond)

A bond whose interest payments fluctuate based on changes in a specified benchmark interest rate, such as Treasury bill rates. These bonds have less interest rate risk than fixed-rate bonds.

Zero-Coupon Bond

A bond that does not make periodic interest payments. Instead, it is sold at a deep discount and pays the full par value at maturity. The investor’s return is the difference between the purchase price and par value. Zero-coupon bonds are subject to phantom income taxation and experience greater price volatility.

Interest Rate Risk

The risk that bond prices will decline as interest rates rise. This risk exists because bond prices and interest rates move in opposite directions. Longer maturities and lower coupon rates increase interest rate risk.

Basis Point (bps)

A unit of measurement equal to one one-hundredth of a percentage point, or 0.01%. One hundred basis points equal one percent and are commonly used to describe small changes in interest rates or yields.

Maturity

The date on which a bond issuer repays the principal amount to the bondholder. Longer-maturity bonds generally pay higher interest rates but are more sensitive to changes in interest rates.

Term Bonds

Bond issues in which all bonds mature on the same date in the future.

Serial Bonds

Bond issues in which portions of the total issue mature at different dates, often annually, rather than all at once.

Sinking Fund

A provision requiring the issuer to periodically set aside funds in an escrow account to ensure the availability of money for bond redemption. A sinking fund reduces credit risk and increases the safety of the bond issue.

Callable Bond

A bond that allows the issuer to redeem the bond prior to maturity at a specified price. Callable bonds are typically redeemed when interest rates fall, allowing the issuer to refinance at lower rates.

Call Premium

The amount paid by an issuer above par value when calling a bond early. The premium compensates investors for the loss of future interest payments.

Refunding

The process by which an issuer calls existing bonds and issues new bonds at a lower interest rate when market rates decline, similar to refinancing a mortgage.

Call Protection

A period during which a callable bond cannot be redeemed by the issuer, providing temporary protection to investors.

Puttable Bond

A bond that gives the investor the right to demand early repayment of principal from the issuer under specified conditions. Because this feature benefits investors, puttable bonds generally offer lower yields.

Nominal Yield (NY)

The bond’s stated coupon rate, calculated as annual interest divided by par value. Nominal yield is fixed and does not change over the life of the bond.

Current Yield (CY)

A bond’s annual interest payment divided by its current market price. Current yield changes as the bond’s market price fluctuates.

Yield to Maturity (YTM)

The total return an investor can expect if a bond is held until maturity. YTM considers the bond’s price, coupon payments, time to maturity, and assumes reinvestment of coupons at the same yield.

Yield to Call (YTC)

The return an investor earns if a callable bond is redeemed on the first call date. For premium bonds, YTC is lower than YTM; for discount bonds, YTC is higher than YTM.

Interest Rate Risk Ranking

A principle stating that bonds with longer maturities and lower coupon rates experience greater price volatility when interest rates change, while short-term and high-coupon bonds are less sensitive.

Call Risk

The risk that a bond will be redeemed early by the issuer when interest rates fall, forcing investors to reinvest at lower yields.

Reinvestment Rate Risk

The risk that interest payments or returned principal must be reinvested at lower prevailing interest rates. Zero-coupon bonds do not have reinvestment risk because they pay no periodic interest.

Inflation Risk (Purchasing Power Risk)

The risk that inflation will reduce the real value of a bond’s fixed interest payments and principal repayment over time.

Credit Risk (Default Risk)

The risk that an issuer will fail to make interest payments or repay principal. Issuers with higher credit risk must offer higher yields to attract investors.

Investment-Grade Bonds

Bonds rated BBB- (Baa3) or higher by rating agencies, indicating lower default risk and lower yields.

Non-Investment-Grade Bonds (Junk or High-Yield Bonds)

Bonds rated below investment grade that carry higher default risk but offer higher yields to compensate investors.

Credit Ratings

Evaluations issued by rating agencies such as S&P, Moody’s, and Fitch that assess an issuer’s ability to meet its debt obligations. Ratings may change over time.

EMMA (Electronic Municipal Market Access)

A public online database operated by the Municipal Securities Rulemaking Board that provides information on municipal bond issuers, prices, disclosures, and credit ratings.

Accrued Interest

Interest that has accumulated since the last coupon payment but has not yet been paid. When a bond is sold between coupon dates, the buyer pays accrued interest to the seller.

Day-Count Convention

The method used to calculate accrued interest. Corporate, municipal, and agency bonds use a 30-day month and 360-day year, while Treasury securities use actual days and a 365-day year.

Settlement Date

The date on which ownership of a bond officially transfers from seller to buyer. Regular-way settlement for bonds is T+1, meaning one business day after the trade date.

Trading Flat

A bond trading without accrued interest, typically because the bond is a zero-coupon bond or is in default.

Cost Basis

The value of a bond for tax purposes, used to calculate capital gains or losses if the bond is sold prior to maturity.

Accretion

The process of increasing the cost basis of a discount bond each year so that it equals par value at maturity, calculated using the straight-line method.

Amortization

The process of decreasing the cost basis of a premium bond each year so that it equals par value at maturity, calculated using the straight-line method.