Fixed Income Securities: Government and Corporate Bonds
Pricing, yield, and credit
Fixed income questions test the relationship between price and yield, the meaning of accrued interest, and the distinction between clean and dirty prices. Candidates must understand yield to maturity, yield to call, and current yield, and when each is the appropriate measure. Know the structure of the government curve, the role of benchmark issues, and how credit spreads compensate for default, liquidity, and risk appetite.
Concepts to master
Understand coupon structures: fixed, floating, zero-coupon, and step-up. Know the meaning of duration and convexity at a conceptual level, and how each measures sensitivity to rate changes. Understand call and put features, sinking funds, and covenants. Know the difference between senior secured, senior unsecured, and subordinated debt, and the recovery implications. Understand the mechanics of a new issue versus a secondary trade, including the role of the dealer in each.
Traps
A common trap is treating a bond quoted on a clean price basis as if accrued interest were included. Another is assuming a higher coupon means a higher yield; the price paid determines the yield. Watch for questions where a bond is trading at a premium and the candidate must recognise that yield to maturity is below the coupon. Also watch for confusion between credit spread widening and a change in the risk-free rate.
Worked example
A bond with a 5% coupon trades at a price above par. The current yield is below 5% because the coupon is divided by a price above 100. Yield to maturity is lower still, because the investor also faces a capital loss at maturity. Any answer that reports a yield above the coupon for a premium bond is wrong.
Rule of thumb
Premium means yield below coupon; discount means yield above coupon. Anchor every yield question to that relationship before calculating.