Fixed Income Securities

Fixed income securities are debt instruments where the issuer borrows money from investors and promises to repay the principal plus interest. Bonds provide predictable income streams and serve as portfolio stabilizers, but they carry risks that every financial planner must understand.

Bond Characteristics

Every bond has three fundamental characteristics:

Par Value (Face Value): The amount the issuer will repay at maturity, typically $1,000 for corporate bonds. This is also the basis for calculating coupon payments.

Coupon Rate: The annual interest rate paid on the bond, expressed as a percentage of par value. A bond with a 6% coupon and $1,000 par value pays $60 per year (typically $30 semi-annually).

Maturity Date: When the issuer repays the par value to the bondholder. Maturities range from short-term (1-3 years) to long-term (10-30+ years).

Types of Bonds

Treasury Securities are issued by the U.S. federal government and backed by its full faith and credit:

• Treasury Bills (T-Bills): Maturities under 1 year; sold at discount, mature at par
• Treasury Notes: Maturities of 2-10 years; pay semi-annual interest
• Treasury Bonds: Maturities greater than 10 years; pay semi-annual interest
• TIPS (Treasury Inflation-Protected Securities): Principal adjusts with inflation; coupon rate stays fixed
• STRIPS: Zero-coupon securities created by separating Treasury coupon payments from principal

All Treasury interest is exempt from state and local taxes (but subject to federal tax).

Municipal Bonds are issued by state and local governments:

• General Obligation (GO) Bonds: Backed by the full faith, credit, and taxing authority of the issuer
• Revenue Bonds: Backed only by revenues from a specific project (toll roads, airports, utilities)
• Interest is typically exempt from federal taxes and from state taxes if you live in the issuing state
• Bonds from U.S. territories (Puerto Rico, Guam) are triple tax-exempt for all U.S. investors

Corporate Bonds are issued by corporations:

• Subject to federal, state, and local taxes
• Higher yields than comparable government bonds to compensate for credit risk
• May be secured (backed by collateral) or unsecured (debentures)
• Callable bonds can be redeemed early by the issuer, typically at a premium

The Price-Yield Relationship

Bond prices and interest rates move in opposite directions. This is the most fundamental concept in fixed income investing.

When market interest rates rise:

• Newly issued bonds offer higher coupon rates
• Existing bonds with lower coupons become less attractive
• Existing bond prices fall to make their yields competitive

When market interest rates fall:

• Newly issued bonds offer lower coupon rates
• Existing bonds with higher coupons become more attractive
• Existing bond prices rise

Current Market Context (January 2026): The 10-year Treasury yield is approximately 4.5%, with the 2-year Treasury at roughly 4.2% and the 30-year at about 4.8%. These rates reflect current Federal Reserve policy and market expectations for inflation and economic growth.

Yield Measures

Understanding different yield calculations is critical for the CFP exam:

Coupon Rate (Nominal Yield): Annual coupon payment divided by par value.

• Formula: Annual Coupon / Par Value
• Example: $60 / $1,000 = 6%

Current Yield: Annual coupon payment divided by current market price.

• Formula: Annual Coupon / Market Price
• Example: $60 / $950 = 6.32%

Yield to Maturity (YTM): The total return earned if the bond is held to maturity, assuming all coupons are reinvested at the same rate. YTM accounts for:

• Current income from coupon payments
• Capital gain or loss at maturity
• Time value of money

Yield to Call (YTC): The return earned if the bond is called at the first call date. Relevant for callable bonds trading at a premium.

Yield Relationships for Premium and Discount Bonds

The relationship between yields depends on whether the bond trades at a premium, par, or discount:

CFP Exam Tip: Memorize "Premium bonds: High to Low (CR > CY > YTM > YTC)" and "Discount bonds: Low to High (CR < CY < YTM < YTC)".

Duration

Duration measures a bond's sensitivity to interest rate changes. It represents the weighted average time until the investor receives all cash flows.

Key duration relationships:

• Longer maturity = Higher duration (more time for rates to affect value)
• Lower coupon = Higher duration (more weight on final payment)
• Lower YTM = Higher duration (future cash flows worth more)
• Higher duration = Greater price volatility

Zero-coupon bonds: Duration equals maturity because there are no interim cash flows.

Using duration to estimate price change:

• If duration is 5 years and rates rise 1%, the bond price falls approximately 5%
• If duration is 5 years and rates fall 1%, the bond price rises approximately 5%

Immunization: Matching portfolio duration to the investor's time horizon protects against interest rate risk. When duration equals time horizon, interest rate risk and reinvestment risk offset each other.

Credit Ratings

Credit rating agencies assess the likelihood that bond issuers will meet their obligations. The three major agencies are Moody's, Standard & Poor's (S&P), and Fitch.

Investment grade: BBB-/Baa3 or higher. Many institutional investors can only hold investment-grade bonds.

High yield (junk bonds): BB+/Ba1 or lower. Higher yields compensate for higher default risk.

Recent Rating Note: In 2025, the United States lost its last AAA credit rating when Moody's downgraded it to Aa1, joining S&P and Fitch in rating U.S. debt below the top tier.

Tax-Equivalent Yield

When comparing municipal bonds to taxable bonds, calculate the tax-equivalent yield:

Tax-Equivalent Yield = Municipal Yield / (1 - Marginal Tax Rate)

Example: A municipal bond yields 4%. For an investor in the 32% tax bracket:

• Tax-equivalent yield = 4% / (1 - 0.32) = 4% / 0.68 = 5.88%
• The muni is better than a taxable bond yielding less than 5.88%

After-Tax Yield of Taxable Bond = Taxable Yield x (1 - Marginal Tax Rate)

Example: A corporate bond yields 6%. For an investor in the 32% tax bracket:

• After-tax yield = 6% x (1 - 0.32) = 6% x 0.68 = 4.08%

Bond Risks

CFP Exam Tip: Interest rate risk and reinvestment risk work in opposite directions. Duration matching (immunization) balances these two risks.