2.1 Bond Fundamentals
Key Takeaways
- Bonds are debt securities; bondholders are creditors, not owners.
- Par value is typically $1,000 and the coupon rate is fixed at issuance.
- Bond prices move inversely with interest rates.
- Premium, par, and discount pricing reflect market rates vs. the coupon.
- Corporate/muni accrued interest uses 30/360; Treasuries use actual/actual.
What a Bond Is
A bond is a debt instrument: the issuer borrows money from investors, promises to repay the principal (face value) at maturity, and pays periodic interest in between. Buying a bond makes you a creditor of the issuer, not an owner. This is the single most-tested distinction on the Series 7: a stockholder has an ownership (equity) stake and votes; a bondholder has a fixed claim that ranks ahead of all equity in a liquidation but carries no voting rights and no upside beyond the promised interest.
Three parties appear in nearly every bond question:
- Issuer — the borrower (a corporation, the U.S. Treasury, or a municipality).
- Bondholder — the lender who receives interest and the return of principal.
- Trustee — a bank or trust company that enforces the indenture (the legal contract of covenants) on behalf of bondholders. The Trust Indenture Act of 1939 requires a trustee for public, non-exempt corporate issues of $50 million or more.
Core Terms You Must Know Cold
- Par value (face value): the amount repaid at maturity. For corporate and municipal bonds this is $1,000 per bond. (Note: muni quotes and Treasury quotes look different but par is still $1,000.)
- Coupon (nominal yield): the fixed annual interest rate as a percent of par. A 6% bond on $1,000 par pays $60 per year. Most bonds pay semiannually, so that is $30 every six months. The coupon never changes once set at issuance.
- Maturity: the date par is returned. Classifications: short-term (1–3 yr), intermediate (4–10 yr), long-term (>10 yr).
Bond Pricing and the Inverse Relationship
A bond's market price moves opposite to market interest rates, because the coupon is locked. If new bonds offer 7% and your bond pays 5%, no one pays full price for yours — its price falls until its yield matches the market. This produces the three pricing states tested constantly:
| Price state | Dollar price | Market rate vs. coupon |
|---|---|---|
| Premium | Above $1,000 | Market rate < coupon |
| Par | $1,000 | Market rate = coupon |
| Discount | Below $1,000 | Market rate > coupon |
Trap: "interest rates rise" means market rates; the coupon on an outstanding bond never moves. Rising rates push existing prices down.
Quotation Conventions
Corporate bonds are quoted as a percentage of par in decimals; a quote of 98 = 98% × $1,000 = $980. Municipal bonds are commonly quoted on a yield (basis) or dollar basis. Treasury notes/bonds are quoted in 32nds: a quote of "99-16" means 99 and 16/32, or 99.50% of par = $995.00.
| Quote | Type | Dollar price |
|---|---|---|
| 98 | Corporate (% of par) | $980 (discount) |
| 103.50 | Corporate | $1,035 (premium) |
| 99-16 | Treasury (32nds) | $995.00 |
Accrued Interest
Between coupon dates, interest accrues to the seller. A secondary-market buyer pays the price plus accrued interest, because the buyer will collect the entire next coupon and must reimburse the seller for the days the seller actually held the bond. Trades settle T+1 (regular-way, effective May 28, 2024).
Accrued Interest = (Annual Interest ÷ days-in-year) × days held
| Bond type | Day-count convention |
|---|---|
| Corporate | 30/360 |
| Municipal | 30/360 |
| U.S. Treasury | actual/actual |
Accrued interest counts from the last coupon date up to but not including the settlement date.
Worked example (30/360): A 6% corporate bond, last coupon Jan 1, settling Mar 15. Days = Jan (30) + Feb (30) + Mar (15) = 75. Accrued = ($60 ÷ 360) × 75 = $12.50. Notice that under 30/360 every month is treated as exactly 30 days and the year as exactly 360 days, regardless of the calendar; this is why corporate and municipal accrued-interest answers come out in clean fractions while Treasury answers, which use the actual calendar, rarely do.
A bond that trades flat carries no accrued interest. The most common flat-trading situations the exam tests are bonds in default (the issuer is not paying interest, so none accrues to the buyer) and income (adjustment) bonds, which pay interest only when earnings are sufficient and the board declares it. Zero-coupon bonds also trade flat because they make no interim coupon payments. Outside those cases, assume a secondary-market trade settles with accrued interest added to the buyer's price and credited to the seller.
Understanding why debt is such a large part of the test helps you prioritize. Debt securities make up a substantial share of the Series 7's 125 scored questions, and the pricing, yield, and accrued-interest mechanics introduced here recur throughout the municipal, government, and options chapters. A client who buys a bond is lending money and accepting a fixed, contractual return; the representative's job is to match the bond's maturity, coupon, credit quality, and call features to the client's objectives, time horizon, and risk tolerance.
Mastering the vocabulary now — issuer, par, coupon, maturity, premium, discount, accrued interest — makes every later debt topic far easier, because each builds directly on these fundamentals rather than introducing wholly new ideas.
On the Exam
Expect heavy testing of the inverse price/rate relationship, 30/360 accrued-interest math, recognizing when a bond trades flat versus with accrued interest, distinguishing premium from discount by comparing the market rate to the coupon, and remembering that the coupon is fixed while the market price floats.
A bond with a 5% coupon is trading at 97. This bond is selling at:
A corporate bond pays 6% annual interest. The last coupon was paid April 1, and the trade settles June 15. Using the 30/360 convention, the accrued interest is:
A U.S. Treasury note is quoted at 99-16. The dollar price of one $1,000 note is:
If market interest rates decrease, the prices of outstanding bonds will: