In 1693, England was at war with France and nearly broke. King William III needed money fast. His solution: sell bonds to the public—promises to repay with interest. The Bank of England was created specifically to manage this debt. That basic structure—borrow now, pay interest later, repay principal at maturity—hasn't changed in over 300 years.
Today, the U.S. bond market exceeds $50 trillion. If you're going to advise clients on fixed income, you need to understand how these instruments work at a fundamental level.
Section 1: Bond Basics and Pricing
Why This Section Matters
When investors lend money to corporations, governments, or municipalities, they receive bonds as evidence of that loan. Unlike equity investors who hope for growth, bond investors want predictability: regular interest payments and return of their principal. The trade-off is upside potential for downside protection—bondholders get paid before stockholders if a company fails.
What Is a Bond?
The word "bond" comes from the same root as "bind"—as in a binding agreement. When you buy a bond, the issuer is legally bound to pay you. This legal obligation is what makes bonds fundamentally different from stocks. A company can skip dividends without consequence; skip a bond payment and creditors can force bankruptcy.
A bond is a fixed-income security that represents a loan from an investor to an issuer that needs capital—typically a corporation, government entity, or municipality. The issuer promises to pay interest periodically and repay the principal (the original loan amount) at maturity.
| Perspective | Role |
|---|---|
| Bond Issuer | Borrower = Debtor |
| Bond Investor | Lender = Creditor |
Unlike stockholders who own a piece of the business, bondholders are creditors who are owed money. The bond itself is evidence of the issuer's indebtedness to the investor.
Par Value and Coupon Rate
Bonds are issued with a stated face value called par value—typically $1,000 for corporate and government bonds. The bond pays interest based on its coupon rate (also called the stated rate or nominal yield)—the annual interest rate applied to the par value.
ABC Corporation issues a $1,000 par value bond with an 8% coupon rate.
Annual interest = $1,000 × 8% = $80 per year
Interest is typically paid semiannually, so the bondholder receives $40 every six months.
At maturity, the investor receives the final coupon payment ($40) plus the $1,000 principal = $1,040 total
Test Tip: Unless told otherwise, assume bond interest is paid semiannually. Read carefully—some questions ask for annual interest ($80), others ask for the next semiannual payment ($40). This is a common trap.
Bond Certificate Types
| Certificate Type | Description | Status |
|---|---|---|
| Bearer Bonds | No owner name; whoever holds the bond collects payments | No longer issued |
| Registered Bonds | Owner's name printed; must be endorsed to transfer | Largely replaced |
| Book-Entry Bonds | Electronic ownership record; no physical certificate | Current standard |
When bonds are held in street name, the broker-dealer is listed as owner rather than the customer. The customer remains the beneficial owner and retains all benefits—interest payments, transfer rights, and principal repayment.
Test Tip: U.S. government and agency securities are now issued only in book-entry form. No paper certificates exist for new Treasury issues.
(Anyone who's watched a heist movie knows bearer bonds are the villain's favorite—anonymous and negotiable. That's exactly why they were phased out. The IRS prefers knowing who owns what.)
Bond Structure
Term Bonds
A term bond issue has every bond maturing on the same date with the same interest rate. Corporate bonds and U.S. government bonds are typically term bond issues.
ABC Corporation issues $1,000,000 of 8%, $1,000 par bonds, all maturing in 30 years.
Every bond within the issue is identical—same maturity date, same coupon rate, same payment schedule.
Zero-Coupon Bonds
Zero-coupon bonds pay no periodic interest. Instead, they're sold at a deep discount from par and redeemed at full par value at maturity. The difference between purchase price and redemption value represents the interest earned.
A 30-year zero-coupon bond is issued at $400.
At maturity, the bondholder receives $1,000 par value.
The $600 difference ($1,000 - $400) represents the interest that would have been paid over 30 years—just received all at once at the end.
Zero-coupon bonds solve a specific problem: reinvestment risk. With regular bonds, you receive interest payments and must find somewhere to invest them. With zeros, there's nothing to reinvest—your return is locked in at purchase. Investors saving for a specific future goal (like college tuition in 18 years) love this certainty.
Serial Bonds
A serial bond issue matures in stages over several years rather than all at once. Part of the principal is repaid at set intervals until the entire issue is retired. Because different maturities carry different risk levels, serial bonds have varying interest rates.
In 2022, the City of Los Angeles issued $10,000,000 of serial bonds:
| Maturity | Interest Rate | Amount |
|---|---|---|
| 2028 | 5.20% | $1,000,000 |
| 2029 | 5.30% | $1,000,000 |
| 2030 | 5.40% | $1,000,000 |
| 2031 | 5.50% | $1,000,000 |
| 2032 | 5.60% | $1,000,000 |
| 2033 | 6.00% | $5,000,000 |
Longer maturities command higher rates. The largest portion maturing last is called a balloon maturity.
Most municipal bonds and corporate equipment trust certificates are issued as serial bonds.
Series Bonds
Series bonds have the same maturity but different issuance dates. They're used for long-term construction projects where funds aren't needed all at once.
Instead of issuing $10,000,000 today, a corporation creates a series bond issue:
- Year 1: $5,000,000 issued
- Year 2: $3,000,000 issued
- Year 3: $2,000,000 issued
All bonds mature on the same date, but they were sold at different times.
Test Tip: Don't confuse serial and series bonds—they sound similar but are opposites:
- Serial: Same issuance date, different maturity dates
- Series: Different issuance dates, same maturity date
Bond Pricing and Quote Spreads
Bond Quotes: Percentage of Par
Most bonds are quoted as a percentage of par value. One bond point equals 1% of par, which is $10 for a $1,000 par bond.
For whole-number quotes, simply add a zero to get the dollar price.
| Quote | % of Par | Dollar Price |
|---|---|---|
| 80 | 80% | $800 (discount) |
| 100 | 100% | $1,000 (par) |
| 110 | 110% | $1,100 (premium) |
Fractional Bond Quotes
Corporate and municipal bonds are quoted in eighths (1/8 = $1.25).
Step 1: Convert the fraction to a decimal (divide numerator by denominator)
Step 2: Move the decimal one place right to get the dollar amount
A bond is quoted at 70 1/8:
Step 1: 1/8 = 0.125, so the quote is 70.125% of par
Step 2: Move decimal right → $701.25
U.S. government bonds are quoted in thirty-seconds (1/32 = $0.3125).
A Treasury bond is quoted at 80.8 (meaning 80 and 8/32):
Step 1: 8/32 = 0.25, so the quote is 80.25% of par
Step 2: Move decimal right → $802.50
Test Tip: Government bonds use 32nds (and sometimes 64ths). Corporate/municipal bonds use 8ths. This is a frequent exam question.
Bid-Ask Spread
Dealers buy and sell bonds from their own inventory. Their quotes have two parts:
| Term | Definition | From Investor's View |
|---|---|---|
| Bid | Price dealer will pay to buy from you | Price you receive when selling |
| Ask (Offer) | Price dealer will accept to sell to you | Price you pay when buying |
The spread is the difference between bid and ask—this is how dealers profit.
Dealer quotes: Bid 98, Ask 100
- If you sell to the dealer: you receive $980 (bid price)
- If you buy from the dealer: you pay $1,000 (ask price)
- Dealer's profit: $20 spread (2 points × $10)
Test Tip: Remember: the ask is always higher than the bid. Investors always get the worse end—pay high (ask) when buying, receive low (bid) when selling.
Bond Quotes: Yield Basis
Some bonds—particularly municipal serial bonds—are quoted based on yield rather than price. Basis points (bps, pronounced "bips") are the standard unit: 1 basis point = 0.01% = 0.0001.
| Basis Points | Percentage | Decimal |
|---|---|---|
| 1 bp | 0.01% | 0.0001 |
| 10 bps | 0.10% | 0.001 |
| 100 bps | 1.00% | 0.01 |
Bond A yields 5%, Bond B yields 6%.
The yield difference = 1% = 100 basis points
If Bond A yields 4.50% and Bond B yields 5.00%, they're 50 basis points apart.
| Bond Type | Quote Method | Structure |
|---|---|---|
| Corporate | % of par (8ths) | Term bond |
| U.S. Government | % of par (32nds) | Term bond |
| Municipal (term) | % of par (dollar bonds) | Term bond |
| Municipal (serial) | Yield basis | Serial bond |
| Concept | Key Details |
|---|---|
| Bond Relationship | Issuer = borrower/debtor; Investor = lender/creditor |
| Par Value | Face value, typically $1,000; basis for coupon payments |
| Coupon Rate | Annual interest rate on par value; usually paid semiannually |
| Term Bonds | All bonds mature same date (corporate, government) |
| Serial Bonds | Staggered maturities (most municipals) |
| Zero-Coupon | No interest payments; sold at discount, redeemed at par |
| Bond Point | 1% of par = $10 |
| Spread | Ask price minus bid price; dealer's profit |
| Basis Point | 0.01%; 100 bps = 1% |
Section 2: Interest Rates, Prices, and Yields
In 1981, 10-year Treasury bonds yielded nearly 16%—an investor could lock in that rate for a decade with U.S. government backing. Investors who bought then watched their bond prices soar as rates fell over the following years. Those who waited and bought in 2020 at 0.5% rates learned the opposite lesson when rates rose sharply in 2022.
Why This Section Matters
Interest rate risk is the primary risk for bondholders. When rates move, your bond's value moves in the opposite direction. Understanding this inverse relationship—and the different ways to measure bond yields—is essential for advising clients and passing the exam.
The Inverse Relationship Between Price and Yield
When a bond is issued, its coupon rate reflects current market rates for similar securities. But once issued, the bond's market price will fluctuate as interest rates change.
Imagine you own a bond paying 5% when newly issued bonds suddenly pay 6%. Why would anyone buy your 5% bond at full price when they could get 6% elsewhere? They wouldn't—unless your bond's price dropped enough to make its effective yield competitive. This is the fundamental driver of bond price movements.
There is an inverse relationship between interest rates and bond prices:
- When interest rates RISE, existing bond prices FALL
- When interest rates FALL, existing bond prices RISE
Prices adjust so that existing bonds offer yields competitive with newly issued securities.
Scenario 1: Rates Rise
Bond X has a 5% coupon. Market rates rise to 6%.
Bond X becomes less attractive—new bonds pay more. Bond X's price falls until its yield equals 6%.
Result: Bond X trades at a discount (below par).
Scenario 2: Rates Fall
Bond X has a 5% coupon. Market rates fall to 4%.
Bond X becomes more attractive—it pays more than new bonds. Buyers bid up the price.
Result: Bond X trades at a premium (above par).
(Bondholders in 2022 learned this lesson the hard way—the fastest rate increases in 40 years sent bond prices tumbling. Meanwhile, bond investors in the 1980s who locked in 15% yields watched their bond values climb steadily as rates fell over the next four decades.)
Understanding Bond Yields
Yield measures the return an investor earns on a bond. There are several ways to calculate yield, and they tell you different things.
Nominal Yield (Coupon Rate)
Nominal yield is simply the coupon rate—the fixed interest rate stated on the bond. Also called the stated yield.
A 5% coupon bond always has a 5% nominal yield, regardless of what happens to market prices or interest rates. Nominal yield never changes.
Current Yield
Current yield measures the annual return based on what you actually paid for the bond:
Bond: $1,000 par, 5% coupon, trading at $1,000 (par)
Annual Interest = $50
Current Yield = $50 ÷ $1,000 = 5%
At par, current yield equals nominal yield.
Current Yield for Discount Bonds
When a bond trades below par, current yield exceeds nominal yield—you're earning the same dollar interest on a smaller investment.
Bond: $1,000 par, 5% coupon, trading at $909.09 (discount)
Annual Interest = $50
Current Yield = $50 ÷ $909.09 = 5.5%
The investor pays less but receives the same $50 annually—higher effective return.
Current Yield for Premium Bonds
When a bond trades above par, current yield is less than nominal yield—you're earning the same dollar interest on a larger investment.
Bond: $1,000 par, 5% coupon, trading at $1,100 (premium)
Annual Interest = $50
Current Yield = $50 ÷ $1,100 = 4.55%
The investor pays more but receives only $50 annually—lower effective return.
Yield to Maturity (YTM)
Yield to maturity is the most comprehensive yield measure. It accounts for:
- Annual interest payments
- The difference between purchase price and par value at maturity
- Time until maturity
For Discount Bonds:
Nominal Yield < Current Yield < Yield to Maturity
YTM is highest because you also gain the discount when the bond matures at par.
For Premium Bonds:
Nominal Yield > Current Yield > Yield to Maturity
YTM is lowest because you lose the premium when the bond matures at par.
For Par Bonds:
Nominal Yield = Current Yield = Yield to Maturity
All yields equal when trading at par.
Test Tip: You won't calculate YTM on the exam, but you must know: for discount bonds, YTM > current yield. For premium bonds, YTM < current yield. Remember: discounts add to your return; premiums subtract.
Yield-Based Quotes and Price Movement
When bonds are quoted on a yield basis (common for municipal serial bonds), the inverse relationship still applies:
Bond B: 5% coupon, quoted at 5.00% yield
Result: Trading at par (yield = coupon)
Bond B: 5% coupon, quoted at 5.50% yield
Result: Trading at a discount (yield > coupon)
Bond B: 5% coupon, quoted at 4.50% yield
Result: Trading at a premium (yield < coupon)
For yield-based quotes:
- When quoted yield rises, dollar price falls
- When quoted yield falls, dollar price rises
The inverse relationship holds regardless of how the bond is quoted.
Test Tip: Questions may describe yield changes in basis points. If a bond's yield rises by 50 basis points, its price fell. If yield drops by 25 basis points, its price rose.
| Concept | Key Details |
|---|---|
| Inverse Relationship | Rates up = prices down; Rates down = prices up |
| Nominal Yield | Coupon rate; never changes |
| Current Yield | Annual interest ÷ market price |
| Discount Bonds | Price < par; CY > NY; YTM highest |
| Premium Bonds | Price > par; CY < NY; YTM lowest |
| At Par | All yields equal |
| Yield-Based Quotes | Yield > coupon = discount; Yield < coupon = premium |
Chapter 2 Key Terms Glossary
| Term | Definition |
|---|---|
| Bond | Fixed-income security representing a loan; pays interest, repays principal at maturity |
| Par value | Face value of bond, typically $1,000; basis for interest calculations |
| Coupon rate | Annual interest rate stated on bond (also: stated rate, nominal yield) |
| Maturity | Date when principal is repaid and bond is redeemed |
| Principal | Original loan amount; repaid at maturity |
| Bearer bonds | Bonds without owner name; whoever holds them collects (no longer issued) |
| Registered bonds | Bonds with owner name; must be endorsed to transfer |
| Book-entry bonds | Electronic ownership record; no physical certificate (current standard) |
| Beneficial owner | Customer who owns bonds held in street name |
| Term bonds | All bonds in issue have same maturity date |
| Serial bonds | Bonds with staggered maturity dates |
| Series bonds | Bonds with same maturity but different issuance dates |
| Zero-coupon bonds | Sold at discount; no interest payments; redeemed at par |
| Bond point | 1% of par value = $10 |
| Basis point (bp) | 0.01% or 0.0001; 100 bps = 1% |
| Bid | Price dealer pays to buy from investor |
| Ask (Offer) | Price dealer charges to sell to investor |
| Spread | Difference between ask and bid; dealer's profit |
| Discount | Bond price below par |
| Premium | Bond price above par |
| Nominal yield | Coupon rate; fixed rate stated on bond |
| Current yield | Annual interest ÷ current market price |
| Yield to maturity (YTM) | Total return including interest and price change to maturity |
| Interest rate risk | Risk that rate changes will affect bond prices |
| Inverse relationship | Rates and bond prices move in opposite directions |
Chapter 2 establishes the fundamentals of debt securities. These concepts—par value, coupon rates, yields, and the inverse relationship—apply to all fixed-income securities covered in later chapters, including corporate bonds, government securities, and municipal bonds.