FINRA Test Prep – Debt Securities

 In this article we’re going to take a look at debt securities. We are going to review how and why someone would purchase a bond. A bond, when purchased by an investor, represents a loan to the issuer in exchange for a stated interest rate. The investor’s relationship with the issuer is as that of a creditor.

You may ask yourself, why would someone buy a bond? The answer is to earn interest. An investor would purchase a bond for the same reason the bank would make a mortgage loan.

Why does a bank lend money to homeowners? It’s not because they want them to have the American dream and to be able to buy a house. It’s because they want to make that loan in exchange for the interest that they will charge them during the term of the loan. So when an investor buys a bond, they are effectively loaning the issuer, whether it be a corporation, the US government, or a state or local municipality, the money in exchange for a stated rate of interest.

Let’s take a look at the  different ways bonds could be issued. Bonds could be issued in bearer form. A bearer bond is one where there is no known owner.

Whoever bears the bond, meaning  whoever possesses the physical bond certificate, he or she is deemed to be the rightful owner, much as if someone has a $20 bill. How do you know he or she is the rightful owner of that $20 bill? They bear, or they possess, that $20 bill, and by all intents and purposes, they’re deemed to be the rightful owner of that $20 bill.

The same  is true with bearer bonds. Bearer bonds  are rarely issued and they certainly aren’t issued in the United States. Once in a while, they will be issued outside of the US, but by and large, they are no longer issued, but we mention them here, because they can show up on your exam.

Most likely, the bonds issued in the United States are going to be registered in one of two ways. A bond  may be registered as to principal only. With a principal only registration, the issuer will know to whom they owe the principal payment at maturity, but the owner will be required to clip coupons to earn their semiannual interest. That’s where the term coupon rate or coupon bond comes from, the fact that investors in bearer bond as well as with bonds registered as to principal only will be required to deposit those coupons in a bank or trust company to collect the semiannual interest payments.

More than likely, most bonds are fully registered, meaning they’re registered as to principal and interest. The issuer knows who to send the semiannual interest payments to, and they know who to send the principal payment at maturity. This is the most common type of bond issuance and worldwide. As we get more and more into the electronic age, more and more bonds are being issued in book entry or journal entry form.

A bond that has been issued in book entry or journal entry form has no physical certificate issued to the investor. Their only evidence of ownership is their confirmation or their brokerage statement. However, this is a fully secure way of purchasing bonds.

Many bonds in the US are only issued in book entry or journal entry form, but they are fully registered. The issuer knows who to send the principal at payment at maturity as well as those semiannual interest payments.

If the issuer does provide a physical certificate to investors, there are certain things that are required to be on that certificate. One is pretty straightforward, the name of the issuer– was it XYZ Corporation, the United States government, or the state of Colorado– the principal amount or par value of the bond must   also appear on the bond certificate. Par value, unless otherwise stated, is going to be $1,000 per bond., and This is a highly testable point and you need to commit it to memory for your exam.

The issue date and the interest payment dates will also be on the bond certificate. There are only two dates during a month that a bond may pay interest. They are the first of the month and the 15th of the month. So they may pay interest on the first of the month and six months thereafter, or on the 15th of the month and six months thereafter.

The place where interest is payable or sometimes referred to as the paying agent–  The paying agent is the party who is responsible for distributing the semiannual interest payments, the type of bond, a reference to any type of collateral, the interest rate, most commonly referred to as the nominal yield  all appear on the bond certificate. The interest rate stated on the bond is the interest rate that is named on the bond, also known as the nominal yield. Additional disclosures required to be made on a bond certificate would include a reference to a call feature, and the trust indenture, if so required.

An indenture is a promise. And many types of bonds are required to have an indenture or a promise to the creditors so that they know what their rights and privileges are in the event of the issuer’s default.

One of the things you will need to master for your upcoming exam is how bonds are priced in the secondary market. Corporate bonds are priced in the secondary market as a percentage of par. And remember that par value is always $1,000 dollars unless otherwise stated.

On your exam, if you see a quote for a corporate bond of 95%, that translates into 95% of $1,000 or $950– this is an example of a bond trading at a discount. If you were to see a quote of 97 1/4, that’s actually 97.25% of par or of $1,000, and that is $972.50. One bond point is equal to 1% of $1,000, or said another way, one bond point is equal to $10.

If you had five bonds and they increased in price by a half of point, each bond would have gone up by $5, and the total value of those five bonds would have increased by a total of $25.

It’s incredibly important to have a comprehensive understanding of the different yields associated with  bonds. The yield is the investor’s return for lending the money or their return for purchasing the bond. The nominal yield once again is the rate that is named on the bond, it’s fixed at issuance and will never change. It doesn’t matter if the bond is trading at $1 or $1 million, the nominal yield will never ever change.

The current yield is very, very important. The current yield is impacted by the pricing of the bond. And it’s always a function of the annual income relative to the current market price. Annual income divided by the current market price tells you the current yield.

The current yield details how much of the Investor’s purchase price he / she would receive  every year in the form of interest payments or interest income, if The investor was to purchase the bond today at the current market price. 

Now let’s take a look at a bond trading at a price below its par value.  A bond trading below its par value is said to be priced at a discount.

Example: 

Again, it doesn’t matter if this bond is trading at a dollar or a million dollars, the nominal yield is always going to be 7%, and the income it generates is always going to be $70.

If we were going to purchase this bond at a price equal to 96, or 96% of par, we’d pay $960. And now, because we purchased that bond at a discount, we see that its current yield is higher than its nominal yield. $70 is a larger percentage of $960 than it is of $1,000. So here we have a scenario where our current yield exceeds the nominal yield, and that’s because we purchased at a price of less than $1,000.

Now, what would happen to our current yield if we purchased that bond at a premium– a price that exceeds par? In our scenario here, we’re going to go ahead and we’re going to buy that same 7% bond, but this time, we’re paying $1,100– a price which is greater than par. We paid $1,100, but we’re still only getting that $70 in annual income. In this scenario, $70 is a smaller percentage of $1,100 than it is of $1,000, and you can see how our current yield is lower than our nominal yield when we purchase a bond at a premium.

A bond’s yield to maturity is the overall return to an investor. It is their most important yield. It is their most important return. If the test asks you what is the market driven rate for an investment in a bond, it is the yield to maturity.

A bond’s yield to maturity takes into consideration the annual interest payments as well as the appreciation or depreciation to par at maturity. When we bought a bond at $960, at maturity we get $1,000, so therefore, we get a little extra bonus at the end. So in that scenario, our yield to maturity will be our highest yield.

Now, when we bought that bond at $1,100, the issuer is only required to pay us $1,000. So in that scenario, our yield to maturity is going to be lower than our current yield, and therefore, we will lose that $100 at maturity. Again, yield to maturity– most important return– it is the market driven rate. The yield to maturity takes into consideration the interest payments received, as well any appreciation or depreciation to par at maturity.

Additionally, the yield to maturity assumes that the investor who receives these interest payments reinvests them at the same rate. When calculating the yield to maturity, Calculation assumes that investors are not taking those interest payments and spending them, but rather reinvesting them at the same rate as they are receiving now.

The relationship between prices and yields is an inverse one. It’s much like a seesaw.

When we bought that 7% bond at $960, our nominal yield was the lowest, our current yield was in the middle, and our yield to maturity was the highest. And again, that’s because we paid $960 for it, but at maturity, we’re getting $1,000. So we’re getting a little bonus of $24 in that scenario. So when prices are low, yields are high. When you buy a bond at a discount, your nominal yield is the lowest, your current yield is in the middle, and your yield to maturity is the highest.

Now, an interesting point here is if this bond was indeed callable, your yield to call would be your highest overall rate, and the reason that’s the case is because we would get the extra $40 bonus in fewer numbers of years. Conversely, when we bought that bond at a premium of $1,100, the price of the bond was high. Our nominal yield of 7% was the highest of all yields, our current yield was in the middle, and our yield to maturity would be our lowest, and that’s because we paid $1,100 for it, but the issuer is only required to pay us $1,000, and we lose that $100 at maturity.

If this bond was callable, our yield to call would extend past our yield to maturity, and therefore, be our lowest of all returns. Not all bonds are callable, but if they are, the yield to call will always extend past the yield to maturity.

Many, many, many bond  questions on your exam can be answered here by drawing the seesaw. And you can answer these questions visually if you can just master the inverse relationship. If you have two children on a teeter totter, one has to go up and one has to go down. They both can’t go up, and they both can’t go down.

But if you buy a bond at a discount, the price is low and the yields are high. Your nominal yield is the lowest, your current yield is in the middle, and your yield to maturity is the highest. When bond prices are high, yields are low. Your nominal yield is the highest when you buy it at a premium, your current yield is then the next lowest, and your yield to maturity would be your lowest return.

And again, remember, should it be callable, your yield to call will extend past your yield to maturity. So when you’re faced with these styles of questions, remember the seesaw. And I’ll give you one more just to make sure you have any possible scenario nailed for your exam.

If you buy a bond at par, $1,000, your nominal yield, your current yield, and your yield to maturity will all be the same. It is whatever is named on the bond. If you buy a bond at par, $1,000, it’s going to mature at $1,000. Therefore, all three of your yields are going to be the same.

Let’s review the  price volatility of bonds. Volatility is an observation of how quickly prices change and how much they change in response to economic or financial conditions. To determine which bond is going to be the most sensitive in price to a change in interest rates, we have to go ahead and compare two bonds.

So if we have a bond which pays 8% maturing in 10 years, and we have another bond paying 8% maturing in 30 years, if interest rates go up or down, the value of these investments are not going to change by the same amount. Each of these bonds are going to pay the investor $80 per year, no matter what happens. Par value is always $1,000. 

A change in interest rates will not impact the price of both of these bonds equally. So if interest rates go from 8% to 10%, these bonds are going to fall in value, because the $80 per year generated by both of these is not as attractive as the 10% or $100 per year that new bonds will now be offering investors.

The question that we need to answer here is which of these bonds will fall the most. They’re both going to fall, but the bond that’s going to fall the most significantly is the bond with 30 years to maturity, and that’s because the investors will be forced to accept this lower interest payment for a very, very long time. So the 30 year bond  is going to fall significantly more than the 10 year bond.

So the bond’s term or life remaining to maturity is a driving factor in how far that bond would fall if interest rates increase. Now, if interest rates increase, bond prices fall, but what if interest rates fall. If interest rates go from 8% to 6%, both of these bonds would increase in value.

And would you rather have a high payment for a long period of time or a high payment for a short period of time? The answer, obviously, is you’d like a high payment for a long period of time and for as long as you can get it.

So if interest rates fell, the bond with the longest term to maturity becomes the most valuable and the 30-year bond would rise by more than its 10-year counterpart. So as interest rates change, the bonds with the longest term to maturity will be impacted the most.

And here are a couple test points for you on questions you may see. An investor would realize the greatest gain on the purchase of a bond by buying long term bonds when rates are high and expected to fall. That would produce the greatest gain for the investor. Alternatively, another style of question might be when would investors suffer the greatest loss on a purchase of a bond, and that would be by buying long term bonds when rates are low and expected to rise.

We’re going to stay with the concept, and we’re good to do a few more illustrations here to make sure you have a firm grasp on this concept, because it is a concept that tends to give test takers a little bit of an issue. So what we’re going to do here is we’re going to put up a couple of bonds here and talk about what happens given a change in interest rates.

Let’s say we have XYZ that issued these bonds some time ago, and the bond had an interest rate, or nominal yield, or a coupon rate of 6%, and maybe they mature 10 years from now. This bond, as we all know from our review, is going to pay investors $70 a year. XYZ, the same company, needs to borrow more money to pay for its operation. So XYZ is issuing new bonds, and these bonds offer investors 9%, and maybe they mature 30 years from now. These bonds are going to pay the investors $90 per year.

So seeing as we’re talking about the same issuer, what has changed? What has changed here is time has passed between the issuance of the 7% bond and the 9% bond, and interest rates have changed. Interest rates have increased from 7% to 9%. As a result, the price of the 7% bond is going to fall. Interest rates have increased over time, and the value of existing bonds, meaning bonds trading in the secondary market, are trading at a discount, because which would you rather have, $90 a year or $70 a year. Everybody would rather have the $90 a year.

Here’s the point that people have a hard time getting their mind around, so to speak. If you’re a new investor who is considering purchasing a bond, and you’re looking at these two bonds, the reality is, it doesn’t matter if you purchase the bond at 7% at a discount or the 9% bond at par, because their yield to maturities are going to approximate each other.

The bond market is very, very, very efficient, and as interest rates change, the value of bonds are priced up or down in relation to that change. So that as new money comes into the bond market, it won’t make a difference to the investors that they buy the 7% at a discount or they buy the 9% at par. Their yield to maturities are going to approximate each other so closely that it doesn’t matter.

Now let’s take a look at it the other way. If the old bonds issued by XYZ offer the investor 9% and they had 10 years to maturity, and the new bonds offer the investor 7% and they have 30 years to maturity, what has happened now? Again, time has passed, and interest rates have changed. Only in this scenario, interest rates have fallen.

Again, the 89 bond is going to pay the investor $90 per year. The 7% bond is going to pay them $70 a year. So what has happened as time has passed and rates have fallen? The bond price of the existing bond has increased.

And again, the yield to maturity, the market driven rate on both of these bonds, is going to approximate each other so that it doesn’t matter which bond you buy, your yield to maturities are going to be very, very, very close to equal. If you can get your mind around some of these concepts, as well as the seesaw, you’re going to be really well positioned to answer these questions on your exam.

Finally, let’s take a look at different types of bond maturities. Bonds mature at their maturity date, and at that time, the investor receives their principal payment of $1,000 plus their last semiannual interest payment. So if we were to take a look at an 8% bond that reaches maturity, what will the investor get at that time? They will get $1,000, the principal amount of the bond, plus they will get their last semiannual interest payment of $40, for a total payment of $1,040. The maturity structure with various bonds can be different.

A term bond– if a corporation borrowed $500 million in a bond issue and it was a term bond, that entire bond issue of $500 million would come due on the same date. So if they matured on June 1 of the following year, they would have to write a check of $500 million on June 1 the following year.

A serial maturity– a serial maturity, as the name implies, has principal portions maturing over a series of years. Maybe if that $500 million issue was a serial issue, they may have, after a period of time, $50 million due for the final 10 years of that issue. That would be a serial style issue.

Or a balloon maturity– with a balloon maturity, there’s going to be some serial payments, and then a large, large payment at the end, or just one big payment, like a balloon mortgage.

We hope that this article has helped you prepare for your exam. 

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 The Securities Institute of America