Section 3 Function 3: Investment Products, Recommendations & Records

Debt securities fundamentals, structured products, and money market instruments

64 min read · Lesson 2 of 19

About This Lesson

Chapter 8 covered ownership; this chapter covers lending, and it front-loads the concepts every later bond chapter leans on. One relationship does most of the work: price and yield move in opposite directions, and everything else, the four yield measures, their premium and discount rankings, duration, follows from it. Get the teeter-totter into your bones here and chapters 10 through 15 become applications instead of new material.

What you'll cover

  • the price/yield seesaw, the four yield measures and their strict premium/discount rankings, and accrued interest under 30/360
  • duration and convexity as the measures of interest-rate sensitivity
  • money market instruments, structured products (ELNs, ETNs, reverse convertibles), foreign debt (Eurodollar bonds versus Eurobonds, sovereign debt), and credit ratings

This is the second chapter of the products module.

In this chapter
64 min · 14 concept checks
§1
Price, Yield, and the Four Measures
~16 min · 4 checks
§2
Duration & Interest Rate Sensitivity
~10 min · 3 checks
§3
Money Market Instruments
~12 min · 3 checks
§4
Structured Products & Foreign Debt
~14 min · 3 checks
§5
Credit Ratings
~5 min · 1 check
Summary
Exam Essentials & Traps
Exam-day review
Section 1 of 5 ~16 min · 4 concept checks

Price, Yield, and the Four Measures

The Price/Yield Relationship: The Teeter-Totter

One relationship runs all of fixed income: bond prices and interest rates move in opposite directions. The logic is mechanical. A bond's coupon is fixed at issuance, so when new bonds arrive paying higher rates, the old bond can compete only by getting cheaper; when rates fall, the old bond's locked-in coupon makes it worth more. Picture a teeter-totter, rates on one side and prices on the other:

Interest rates rise →
Bond prices fall
New bonds issued at higher coupons make existing bonds less attractive. Existing bond prices decline until their yield matches the new market rate. Trading below par = at a discount.
Interest rates fall →
Bond prices rise
Existing bonds with higher coupons become more attractive. Their prices rise until their yield matches the new lower market rate. Trading above par = at a premium.

The Four Yield Measures

There are four ways to measure a bond's return, and the exam tests all four. Know the formula for each and when each is the most relevant measure to use.

Nominal yield
Coupon rate
Formula
Coupon ÷ Par
Measures
Stated rate — never changes after issuance
Ignores market price
Current yield
Income measure
Formula
Coupon ÷ Market price
Measures
Annual income return on today's investment
Ignores gain/loss at maturity
Yield to maturity
Most complete measure
Formula
IRR of all cash flows to maturity
Measures
Total annualized return if held to maturity
Assumes reinvestment at YTM
Yield to call
Callable bonds only
Formula
IRR to call date at call price
Measures
Return if called on first call date
Assumes bond will be called

NCMC mnemonic (for yield ranking at a discount): Nominal < Current < Maturity < Call — when a callable bond trades at a discount, yields rank from lowest to highest: Nominal, Current, YTM, YTC. At a premium, the order reverses.

Ranking the Four Yields: Premium vs. Discount

Price a coupon bond at a premium or a discount and its four yield measures fall into a strict order, the same order every time. The exam tests the rankings directly, so the two columns below are pure memorization, and they pay for themselves many times over:

Bond at PREMIUM (price > 100)
Lowest → Highest yield
1. Yield to Call (YTC) — lowest
2. Yield to Maturity (YTM)
3. Current Yield (CY)
4. Nominal Yield (Coupon) — highest
Bond at DISCOUNT (price < 100)
Lowest → Highest yield
1. Nominal Yield (Coupon) — lowest
2. Current Yield (CY)
3. Yield to Maturity (YTM)
4. Yield to Call (YTC) — highest
Worked example (premium bond): A bond with a 6% coupon trades at $1,100, callable at 102 in five years.
• Nominal yield = 6.00%
• Current yield = $60 / $1,100 = 5.45%
• YTM < CY because the bond pays $1,000 at maturity — a $100 loss amortized over the remaining life.
• YTC even lower because the loss occurs sooner (call premium of $20 doesn’t offset the larger discount).
Order: YTC < YTM < CY < Nominal — matches the table above.
Why issuers do not call discount bonds: calling means paying par or better to retire debt the issuer could buy back below par in the open market. Calls happen on premium bonds, when rates have fallen and refinancing is attractive, which is exactly why YTC sits at the bottom of the premium ranking.

Accrued Interest on Corporate Bonds: The 30/360 Day-Count

Sell a bond between coupon dates and the buyer owes the seller the interest earned so far: from the last coupon date up to, but not including, settlement. Two day-count conventions split the market:

Corporate, Agency, and Muni Bonds
30/360 day-count
Each month is treated as exactly 30 days; each year as 360 days. The convention simplifies calculations across non-equal-length months.
U.S. Treasury Securities
Actual/Actual day-count
Actual calendar days elapsed in the actual length of the year (365 or 366). More precise than 30/360 but used only for Treasuries.

Computing Accrued Interest: Step-by-Step

Worked example: An ABC 8% bond pays interest January 1 and July 1. The buyer settles July 18.

Step 1: Identify the last coupon date — July 1.
Step 2: Count from the last coupon to the day before settlement. Settlement is July 18, so we count through July 17 = 17 days.
Step 3: Daily interest = (annual coupon ÷ 360) = ($80 ÷ 360) = $0.2222 per day.
Step 4: Accrued interest = 17 days × $0.2222 = $3.78 per bond.
The buyer pays this on top of the agreed price; the seller has effectively held the bond for 17 days into the new coupon period.
Counting rules to memorize: include the last coupon date when you start counting, exclude the settlement date when you stop. The bond accrues through the day before settlement, and the seller trades the rest of the coupon period for the accrued cash at settlement.
Worked Examples: Bond Yield and Duration
Problem 1 — Current yield: A bond has a 7% coupon rate, $1,000 par value, and is currently priced at $875. Calculate the current yield.
1
Annual coupon payment = Coupon rate × Par value
7% × $1,000 = $70 per year
2
Current yield = Annual coupon ÷ Current market price
$70 ÷ $875 = 8.00%
3
Yield direction check: Bond is at a discount ($875 < $1,000 par), so current yield (8.00%) must be higher than coupon rate (7.00%). ✓
Current yield = 8.00%. Discount bond rule: coupon rate < current yield < YTM.
Problem 2 — YTM direction (no calculator needed): A bond has a 6% coupon, is priced at $1,080, and matures in 8 years. Without calculating exactly, rank the coupon rate, current yield, and YTM from highest to lowest.
1
Bond is at a premium ($1,080 > $1,000 par).
2
Current yield = $60 ÷ $1,080 = 5.56% → below the 6% coupon rate. ✓
3
YTM must be lower than current yield because at maturity the investor receives only $1,000 (losing the $80 premium). YTM accounts for this capital loss, pulling it below current yield.
4
Premium bond hierarchy: Coupon rate > Current yield > YTM
Ranking (high to low): Coupon rate (6.00%) > Current yield (5.56%) > YTM (<5.56%). For a discount bond the order reverses: Coupon rate < Current yield < YTM.
Problem 3 — Duration and price sensitivity: A bond has a modified duration of 6.5. Interest rates rise by 0.75% (75 basis points). Approximately how much does the bond's price change?
1
Formula: Approximate % price change = −Duration × Rate change
−6.5 × 0.75% = −4.875%
2
The bond price falls approximately 4.875%.
3
Dollar impact example: If the bond was priced at $1,000: $1,000 × 4.875% = $48.75 price decline → new price ≈ $951.25.
4
Why the minus sign: Rates and prices move in opposite directions. A rate increase always causes a price decrease.
Price falls approximately 4.875%. Duration rule: for each 1% rate change, price changes by approximately duration%. A bond with duration 10 is twice as sensitive as one with duration 5.
Concept Check

An investor holds a 10-year, 4% coupon bond purchased at par. Market interest rates subsequently rise to 6%. Which of the following statements is most accurate?

Bond prices and interest rates move inversely. When market rates rise from 4% to 6%, the existing 4% coupon bond becomes less attractive relative to new bonds issued at 6%. Its price falls below par (trades at a discount) until its yield to maturity equals the new 6% market rate. This is the fundamental inverse relationship at the core of all fixed income analysis.
Concept Check

A bond has a 6% coupon rate and is currently priced at $1,080. What is the bond's current yield?

Current yield = Annual coupon / Current market price. Annual coupon = 6% x $1,000 par = $60. Current yield = $60 / $1,080 = 5.56%. Because the bond trades at a premium ($1,080 > $1,000 par), the current yield is lower than the coupon rate — the investor pays more for the same $60 annual income. This is the most commonly tested bond calculation on the Series 7: know that premium bonds have current yield < coupon rate.
Concept Check

A bond with a 6% coupon is currently selling for $900. Which of the following statements is INCORRECT?

The incorrect statement concerns the semiannual payment amount. A 6% bond pays $60 per year regardless of price, structured as two $30 payments six months apart — not $27 each. The coupon rate is fixed against par ($1,000), not against the discounted market price. The other three statements are correct: the bond at $900 is at a discount, current yield = $60 / $900 = 6.67%, and yield to maturity exceeds current yield because the bondholder also gains the $100 difference between the $900 purchase price and $1,000 redemption at maturity, amortized over the remaining life of the bond.
Concept Check

A corporate bond with an 8% coupon is currently quoted at 110, callable at 102 in five years. Which sequence correctly orders the yields from lowest to highest?

For a premium bond, the order from lowest to highest is YTC, YTM, current yield, then nominal. The reasoning: a premium bond will redeem at par, creating a built-in capital loss amortized over the remaining life. Yield to call concentrates that loss into a shorter time frame, making YTC the lowest. Yield to maturity spreads the loss over a longer period, making YTM higher than YTC. Current yield ($80 / $1,100 = 7.27%) ignores the capital loss entirely and considers only the coupon against price. Nominal yield is highest because it computes the coupon against the lower par value. Discount bonds reverse this entire ordering.
Section 2 of 5 ~10 min · 3 concept checks

Duration and Interest Rate Sensitivity

Duration: Measuring Interest Rate Sensitivity

Duration is how the exam asks "how hard does this bond fall when rates rise?" Technically it is the weighted average time to receive the bond's cash flows, but use it as a price-change estimator: a duration of 7 means roughly a 7% loss for every 1% rise in rates.

Factors that increase duration (and thus increase interest rate risk):

  • Longer time to maturity — more cash flows far in the future
  • Lower coupon rate — less cash received early; more weight on final payment
  • Lower yield — future cash flows are discounted at a lower rate, increasing their present value weight

Factors that decrease duration:

  • Shorter time to maturity
  • Higher coupon rate — more cash received early reduces the average time
  • Zero-coupon bonds have the highest duration equal to their maturity because they have only one cash flow at maturity — no coupon payments to reduce the average

Convexity

Duration draws the price/yield relationship as a straight line; the real curve bends. Convexity measures the bend. Positive convexity, the norm for ordinary bonds, is good news for you: prices rise more on a rate drop than they fall on an equal rate rise. Callable bonds can flip to negative convexity near the call price, because the issuer's right to call caps the upside.

Duration: Three Rules That Cover 80% of Duration Questions

Rule 1: a zero-coupon bond always has the highest duration of any bond with the same maturity. With no coupons, the entire cash flow sits at the far end, so all the weight does too.

Rule 2: duration increases with maturity, but at a decreasing rate. A 30-year bond does not carry twice the duration of a 15-year bond, because the 30-year's early coupons still pull real weight.

Rule 3: a portfolio's duration is the weighted average of its holdings' durations. To cut a portfolio's rate sensitivity, swap long-duration bonds for short-duration bonds or cash equivalents, which sit near zero. The exam calls this immunization.
Tool Card: Bond Visualizer

See the price/yield teeter-totter in action — adjust market rates and watch how bond prices respond. Also covers the yield curve, duration concepts, and the NCMC mnemonic for yield types.

Open Bond Visualizer
Concept Check

A bond has a duration of 8 years. If interest rates rise by 1%, the approximate change in the bond's price is:

Duration measures price sensitivity: a bond with a duration of 8 will change in price by approximately 8% for each 1% change in interest rates (in the opposite direction). A 1% rate rise causes approximately an 8% price decline. The formula is: % price change ≈ −duration × change in rates. This approximation works for small rate changes; for larger moves, convexity must also be considered.
Concept Check

Which of the following bonds would have the HIGHEST duration, assuming all bonds have the same time to maturity?

A zero-coupon bond has the highest duration of any bond with the same maturity because it pays no periodic coupons — the only cash flow is the principal at maturity. With all weight concentrated at the end, the weighted average time to receive cash flows equals the full maturity. Coupon-paying bonds receive cash flows earlier (coupon payments), reducing the weighted average and therefore their duration.
Concept Check

A bond's duration is 7 years and interest rates rise by 1%. Approximately how much will the bond's price change?

Duration measures the approximate percentage price change in a bond for a 1% (100 basis point) change in interest rates. If duration = 7, a 1% rise in rates will cause the bond's price to fall by approximately 7%. The relationship is inverse — rates up, prices down. This is why duration is the primary tool for measuring interest rate risk. Convexity captures the non-linear adjustment (actual price falls slightly less than duration predicts for rate increases), but for exam purposes duration x rate change = approximate price change.
Section 3 of 5 ~12 min · 3 concept checks

Money Market Instruments

Money Market Instruments

Money market instruments are short-term debt securities with maturities of one year or less. They are used by governments, corporations, and financial institutions to manage short-term funding needs. The exam tests the key features and issuers of each.

Treasury bills (T-bills)
Issued by the U.S. Treasury. Maturities: 4, 8, 13, 26, or 52 weeks. Sold at discount; no coupon. The most liquid and lowest-risk money market instrument. Exempt from state and local tax.
Commercial paper (CP)
Unsecured short-term promissory notes issued by large, creditworthy corporations. Maturity up to 270 days (exempt from SEC registration beyond this). Sold at discount. Not available to retail investors directly.
Banker's acceptances (BAs)
Short-term drafts accepted (guaranteed) by a bank, used to finance international trade. The bank's acceptance makes them low risk. Maturities: 30 to 180 days. Sold at discount.
Repurchase agreements (repos)
A dealer sells securities and agrees to repurchase them at a higher price at a specified future date. Effectively a collateralized short-term loan. Reverse repo: the dealer buys and agrees to sell back. Used heavily by the Fed for open market operations.
Negotiable CDs
Large-denomination ($100,000+) certificates of deposit issued by banks that can be traded in the secondary market. Pay interest at maturity. Interest income is fully taxable at all levels.
Fed funds rate
The overnight rate at which depository institutions lend excess reserves to each other. Set by the Federal Open Market Committee (FOMC). The most influential benchmark rate — changes cascade through the entire interest rate environment.

Money Market Instruments: The Six Tested Categories

Six short-term instruments make up the tested money market, and the exam usually spends one or two questions asking you to tell them apart. Each card carries the identifying facts that decide those questions:

U.S. Treasury Bills
Government, exempt securities
Maturities of 4, 8, 13, 17, 26, and 52 weeks. Issued at a discount; redeemed at par. The discount represents the entire return. Highest credit quality among money market instruments.
Commercial Paper (CP)
Unsecured corporate short-term
Issued by large corporations to fund short-term operating needs. Maturities of 270 days or less (Section 3(a)(3) registration exemption). Issued at a discount. Backed only by the issuer’s general credit.
Negotiable CDs (Jumbo CDs)
Bank-issued, $100,000 minimum
Tradeable bank CDs with face value of $100,000 or more (often $1M+). FDIC-insured up to $250,000 per depositor per bank. Trade in the secondary market until maturity.
Bankers’ Acceptances (BAs)
Time draft, used for trade finance
Time draft drawn on and accepted by a bank, used to finance international trade. The bank’s acceptance creates a marketable instrument backed by both the importer and the bank.
Repurchase Agreement (Repo)
Short-term collateralized loan
Dealer sells securities with an agreement to repurchase at a slightly higher price on a stated date. Effectively a collateralized overnight or short-term loan; widely used by primary dealers to finance positions.
Reverse Repo
Mirror image of a repo
The buyer’s side of the same transaction — the investor purchases securities with an agreement to sell them back. From the dealer’s perspective, a way to lend cash short-term against collateral.
Jumbo CD insurance trap: Jumbo CDs are insured by FDIC up to $250,000 but are not secured by any specific bank asset. Above the FDIC limit, the holder is a general creditor of the bank. The exam frequently asks "are jumbo CDs secured?" with the answer being no — only insured.
Concept Check

Which of the following money market instruments is used primarily to finance international trade and represents a time draft that has been accepted (guaranteed) by a bank?

A banker's acceptance is a short-term draft used to finance international trade transactions. When a bank "accepts" the draft, it guarantees payment, making it a very low-risk money market instrument. BAs are sold at a discount and have maturities of 30 to 180 days. They differ from commercial paper (general corporate borrowing), negotiable CDs (bank deposits), and repos (collateralized borrowing/lending arrangements).
Concept Check

Which money market instrument is issued by the U.S. government and is always sold at a discount from face value with no periodic interest payments?

Treasury bills are short-term U.S. government obligations issued at a discount from face value and maturing in up to 52 weeks. The investor's return is the difference between the purchase price and the face value received at maturity — there are no coupon payments. T-bills are the most liquid and safest money market instrument. Commercial paper is issued by corporations; banker's acceptances are bank-guaranteed trade finance instruments; Eurodollar deposits are U.S. dollar deposits held at foreign banks.
Concept Check

Which of the following statements about negotiable jumbo certificates of deposit (CDs) is most accurate?

Jumbo CDs are FDIC-insured up to $250,000 per depositor per bank, the same limit applied to all bank deposits. Above the FDIC threshold, the holder is a general creditor of the bank — there is no specific collateral pledge. Insured does not mean secured: insurance is a third-party guaranty up to a cap, while secured implies a collateral interest in specific assets. Jumbo CDs are negotiable by definition — they trade in an active secondary market until maturity. The "insured but unsecured" phrasing is the precise language the exam expects.
Section 4 of 5 ~14 min · 3 concept checks

Structured Products and Foreign Debt

Structured Notes and Mortgage-Backed Securities: An Introduction

Two product families bridge plain bonds and the more exotic chapters ahead. Structured notes customize the return; mortgage-backed securities customize the collateral.

Structured Notes

A structured note is a debt security whose return is tied to a reference asset, index, or rate instead of a plain coupon. Three structures repeat on the exam:

  • Principal-protected notes: Return at least the face value at maturity while offering participation in the upside of an equity index. The bond component provides the principal protection; the embedded option provides the upside exposure.
  • Leveraged notes: Magnify the return (positive or negative) of the reference asset, typically 1.5x to 3x. High risk of loss if the reference declines.
  • Reverse convertible notes: Pay a high coupon, but if the reference asset falls below a barrier, the investor receives shares (or cash equivalent) instead of principal — exposing them to full downside.

Mortgage-Backed Securities (MBS)

Mortgage-backed securities pool home mortgages and pass the principal and interest through to investors pro rata; pass-through certificates from GNMA, FNMA, and FHLMC are the standard form. Two risks belong specifically to MBS, and both grow out of the homeowner's right to prepay:

  • Prepayment risk: When interest rates fall, homeowners refinance and pay off their mortgages early. Investors receive principal back faster than expected and must reinvest at the now-lower rates — a form of call risk
  • Extension risk: When interest rates rise, prepayments slow and the effective maturity of the MBS extends — leaving investors stuck in a below-market security for longer than anticipated

CMOs (collateralized mortgage obligations) are covered in depth in Chapter 15.

Structured Products: ELNs and ETNs

Structured products wrap a debt security around someone else's performance: an equity index, a single stock, a basket, or a commodity. The exam tests two flavors, and the differences are where the risk hides:

Equity-Linked Note (ELN)
Privately placed structured note
Returns linked to the performance of an equity index or basket.
Some are principal-protected (guaranteed return of principal at maturity); others are not.
Typically illiquid — no active secondary market.
Exchange-Traded Note (ETN)
Listed unsecured debt
Trades on an exchange like a stock.
Unsecured debt of the issuer — holders bear credit risk of the issuing bank in addition to market risk.
Tracks an index but does not hold the underlying assets — unlike an ETF.
Heightened suitability standard: FINRA requires heightened suitability scrutiny for structured-product recommendations. Complexity, issuer credit risk, illiquidity, and tax treatment that diverges from the underlying add up to a product that is wrong for many retail customers, and the exam tests whether the phrase "structured product" makes you reach for the higher standard.
"Equity-linked" is still debt: the name describes how the return is calculated, not what you own. ELN and ETN holders are creditors of the issuer, never equity owners, which is why the issuer's credit risk never goes away.

Foreign Debt Securities: Eurobonds, Eurodollar Bonds, and Sovereign Debt

Three categories of foreign debt reach retail customers, and the most-tested distinction in the set is Eurobond versus Eurodollar bond, two names one syllable apart that the exam loves to swap:

Eurodollar Bond
Pays in U.S. dollars
Denominated and pays interest/principal in U.S. dollars.
Issued outside the United States by U.S. or foreign corporations.
Investor bears no foreign-currency risk — returns are dollar-denominated.
Eurobond
Pays in foreign currency
Denominated and pays interest/principal in a non-U.S. currency.
Issued outside the issuer’s domestic market.
Investor bears foreign-currency risk as returns translate at fluctuating exchange rates.
Recognition trick: the name tells you the currency. Eurodollar pays in dollars; Eurobond pays in a foreign currency. Both are issued outside the U.S.; the prefix is the part that matters.

Sovereign Debt

Bonds issued by foreign national governments are sovereign debt: UK Gilts, German Bunds, Japanese Government Bonds (JGBs). Each carries its own bundle of political, currency, and default risk.

Suitability for small retail positions: a customer with a few thousand dollars cannot practically buy individual sovereign bonds; minimum lots and custody costs are prohibitive. The suitable answer is a mutual fund or ETF specializing in foreign debt, which delivers diversification, professional management, and U.S. settlement at a workable minimum.
Concept Check

A registered representative is explaining the differences between Eurodollar bonds and Eurobonds to a customer. Which statement accurately distinguishes the two?

The currency mentioned in the name signals what the holder receives. Eurodollar bonds pay both interest and principal in U.S. dollars, regardless of where they are issued or by whom. Eurobonds pay in a non-U.S. currency — the issuer determines the denomination. Both categories share the trait of being issued outside the issuer’s home country, but the currency distinction is what the exam tests. The reverse mapping (Eurobonds in dollars) is a frequent distractor designed to trip up candidates who memorize the wrong direction.
Concept Check

A retail customer with $2,500 to invest wants exposure to foreign debt securities. The most suitable recommendation is to

A mutual fund or ETF specializing in foreign debt provides diversification, professional credit selection, U.S. settlement, and a practical investment minimum that fits a $2,500 commitment. Individual sovereign or foreign corporate bonds typically trade in lot sizes far above $2,500, and custody plus settlement infrastructure for direct foreign holdings adds material cost. Opening accounts at foreign broker-dealers or routing through foreign branches creates regulatory complexity that does not benefit a retail customer at this dollar amount. The customer’s small size makes pooled investment vehicles the natural recommendation.
Concept Check

FINRA expects firms to apply heightened suitability standards when evaluating recommendations for which of the following?

FINRA requires firms to apply heightened suitability scrutiny to structured products including ELNs and ETNs. The combination of derivative-like returns, issuer credit risk, illiquidity, complex tax treatment, and pricing opacity makes these unsuitable for many retail investors regardless of risk tolerance. Sovereign debt, cumulative preferred stock, and nonvoting common stock all carry suitability obligations under standard FINRA Rule 2111 but do not trigger the heightened review reserved for structured products. The review captures complexity, not simply risk.
Section 5 of 5 ~5 min · 1 concept check

Credit Ratings

Bond Credit Ratings: Investment Grade vs. High Yield

Standard & Poor's and Moody's split the U.S. ratings market, with notation just different enough to test. The line that matters sits in the same place on both scales:

TierS&PMoody’sDescription
Investment GradeAAA, AA, A, BBBAaa, Aa, A, BaaAcceptable for fiduciaries, pensions, insurance companies. Default risk low to moderate.
Speculative / High YieldBB, B, CCC, CC, CBa, B, Caa, Ca, COften called "junk bonds." Higher default risk; higher coupons to compensate. Many institutional fiduciaries are restricted from holding.
In DefaultD(no equivalent)Issuer has missed a payment.
The investment-grade cutoff: BBB at S&P, Baa at Moody's: the lowest rungs of investment grade. One notch below, BB and Ba, and the bond is speculative. ERISA pension plans and many institutional accounts may hold investment grade only, which makes that single notch economically real.

What Credit Ratings Do Not Address

A rating answers exactly one question, how likely is default, and leaves the rest open:

  • Interest rate risk — a AAA bond can lose substantial value if rates rise.
  • Liquidity risk — small or thinly traded issues may be difficult to sell regardless of rating.
  • Reinvestment risk — the risk that interest payments cannot be reinvested at the original yield.
  • Inflation / purchasing-power risk — erosion of the bond’s real return over time.

That is also why issuers pay for ratings: a rating reduces credit-risk uncertainty and lowers the borrowing cost. Every other risk on the list stays with you, the investor, whatever the rating says.

Concept Check

An investor concerned about default risk consults bond ratings before making a fixed-income purchase. Which of the following ratings represents the lowest tier still considered investment grade?

BBB (Standard & Poor’s) and Baa (Moody’s) form the lowest rung of investment-grade debt. Anything below — BB or Ba and lower — is speculative-grade or "junk" debt. The distinction has practical consequence because ERISA-governed pension plans, insurance company general accounts, and many institutional fiduciary mandates restrict holdings to investment grade only. AAA / Aaa and A / A are higher tiers within investment grade. BB / Ba is the highest speculative tier — just below the investment-grade cutoff and a common downgrade target known as a "fallen angel" when an investment-grade bond drops to that level.
Summary Exam-day review · 2 essentials blocks

Chapter Summary — Exam Essentials

Ch 9 Exam Essentials — Debt Securities Fundamentals

  1. Current yield formula: Annual coupon ÷ current market price. A premium bond has current yield < coupon rate; a discount bond has current yield > coupon rate.
  2. Duration rule: Duration ≈ % price change for a 1% rate move. Duration 8 → bond falls ~8% if rates rise 1%. Zero-coupon bonds have duration equal to their maturity (most sensitive). Callable bonds have lower duration than equivalent non-callables.
  3. Convexity: For a given rate increase, actual price decline is slightly less than duration predicts (positive convexity for standard bonds). Callable bonds exhibit negative convexity at low yields.
  4. Money market instruments: T-bills (government, discount), commercial paper (corporations, unsecured, up to 270 days), banker's acceptances (trade finance, bank-guaranteed), repos (short-term collateralized borrowing).
  5. Structured notes and MBS: MBS pass-throughs pass all principal and interest to investors pro-rata. Main risks: prepayment risk (rates fall, homeowners refi) and extension risk (rates rise, prepayments slow).
Debt Securities Exam Traps — Consolidated

Twelve traps the exam keeps in rotation for debt fundamentals. Sweep the list the night before; each one settles a question that has actually been asked:

1. Eurodollar bond pays in dollars; Eurobond pays in foreign currency. The currency in the name is the currency you receive. Both are issued outside the U.S.

2. Sovereign debt = national government, foreign. Recommend mutual funds or ETFs for retail amounts under ~$5,000 — individual sovereign issues have impractical minimum lots.

3. Jumbo CDs are insured (FDIC up to $250K), not secured. Above the FDIC limit, the holder is a general creditor of the bank.

4. CP matures in 270 days or less. The Section 3(a)(3) registration exemption requires this maximum. Issued at a discount, no coupon.

5. Premium bond yield order: YTC < YTM < CY < Nominal. Discount bond order is the reverse: Nominal < CY < YTM < YTC.

6. Issuers don’t call discount bonds. They’d be paying par to retire something they could repurchase below par in the open market. Calls happen on premium bonds when refinancing rates are favorable.

7. ELNs and ETNs are debt, not equity. Despite "equity-linked" in the name, the legal structure is debt. Holders bear issuer credit risk in addition to market risk on the linked asset.

8. Structured products trigger heightened suitability. Complexity, credit risk, illiquidity, and tax treatment that differs from the underlying make these unsuitable for many retail investors.

9. 30/360 for corporates, agencies, munis; actual/actual for Treasuries. Different day-counts, same general formula. Count from last coupon (inclusive) to settlement date (exclusive).

10. Investment-grade cutoff: BBB / Baa. Below this, the bond is speculative grade ("junk"). Many fiduciary accounts are restricted to investment grade only.

11. Ratings address credit risk only. Interest rate risk, liquidity risk, reinvestment risk, and inflation risk are not captured. A AAA bond can still lose 30% if rates spike.

12. Annual coupon rate, paid semiannually. A "6% bond" pays $60 per year, structured as $30 every six months. The exam tests whether you remember the rate is annual.
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