Characteristics Affecting Valuation

These characteristics rarely act alone. A callable, long-duration municipal bond stacks call risk, rate risk, and a tax advantage into one instrument, so weighing all three together, not just one feature in isolation, matters for a suitable recommendation.

How Is Bond Interest Taxed?

Not all bond interest is taxed equally, and tax treatment directly affects the after-tax yield an investor actually earns.

• Municipal bonds offer the biggest tax advantage: interest is generally exempt from federal income tax
• If you buy a muni issued in your home state, the interest is typically exempt from state and local tax too (this is called triple tax-exempt)
• Treasury securities split the difference: you pay federal tax on the interest, but it's exempt from state and local tax
• Corporate bonds have no tax advantages; interest is fully taxable at all levels

Think of it this way: A municipal bond yielding 3% may actually deliver more after-tax income than a corporate bond yielding 4%, depending on the investor's tax bracket. That's why tax-equivalent yield comparisons matter.

Where Should a Municipal Bond Be Held?

A municipal bond belongs in a taxable account owned by an investor in a high marginal bracket. The exemption is already priced into the yield: a muni pays less than a comparable taxable bond precisely because the interest escapes federal tax. The investor buys the exemption by accepting that lower yield, so the trade only works where there is a tax to escape.

Exam Tip: Gotchas

• A common mix-up: the tax exemption on munis applies only to interest income, not capital gains. If you sell any bond (including munis) at a profit, the capital gain is still taxable.
• A municipal bond inside a retirement account is a classic unsuitable recommendation. Tax shelters do not stack. The investor gives up yield to avoid a tax the account already defers or eliminates.
• A traditional account makes the result worse than neutral. Every distribution from a traditional Individual Retirement Account (IRA) or 401(k) is ordinary income, so the municipal bond's exempt interest is taxed on the way out.
• The same logic reaches any tax-exempt investor. A pension plan or a charitable foundation owes no federal income tax, so recommending municipal bonds to one fails suitability for the identical reason.

How Does Liquidity Affect a Bond's Price?

• Liquidity measures how easily a bond can be bought or sold without significantly moving its price
• More liquid bonds tend to trade at slightly higher prices (lower yields) because investors value the ability to exit quickly

Liquidity hierarchy (most to least liquid):

1. U.S. Treasuries: the most liquid bond market in the world, with massive daily trading volume
2. Agency bonds (Fannie Mae, Freddie Mac): very liquid, but slightly less than Treasuries
3. Investment-grade corporate bonds: reasonably liquid for large issues
4. Municipal bonds: less liquid; many issues trade infrequently
5. High-yield corporate bonds: least liquid, with wide bid-ask spreads

• Less liquid bonds must offer higher yields to compensate investors for the difficulty of selling
• During market stress, liquidity can evaporate quickly, even for bonds that are normally liquid

Who Gets Paid First If an Issuer Liquidates?

When a company goes bankrupt, not all investors are treated equally. Bonds have a clear advantage over equity.

Priority of claims in liquidation (highest to lowest):

1. Secured bonds (backed by specific collateral)
2. Unsecured bonds / debentures (backed only by the issuer's creditworthiness)
3. Subordinated debentures
4. Preferred stock
5. Common stock

• Bonds (debt) always have priority over both preferred and common stock
• Among bonds, secured bonds get paid first because they have a claim on specific assets
• Debentures are unsecured bonds; they rely entirely on the issuer's ability to pay

Exam Tip: Gotchas

"Debenture" sounds fancy, but it just means unsecured. A debenture holder has no claim to specific assets; they're in line behind secured bondholders if the company liquidates.

What Happens When a Bond Is Callable?

A callable bond gives the issuer the right (but not the obligation) to redeem the bond before its maturity date, usually at a call premium above par value.

• Issuers call bonds when interest rates fall so they can refinance at lower rates (just like refinancing a mortgage)
• Call risk is the risk that investors must reinvest their returned principal at lower prevailing rates
• To compensate for this risk, callable bonds offer higher yields than comparable non-callable bonds

• When interest rates drop significantly, a callable bond's price stops rising near its call price. This is called negative convexity
• Most callable bonds have a call protection period during which the issuer cannot call the bond

Exam Tip: Gotchas

Negative convexity only kicks in once rates fall far enough that a call becomes likely. Above that point, a callable bond's price behaves like any other bond; the price ceiling is a rate-dependent effect, not a fixed cap.

How Do Coupon and Zero-Coupon Bonds Differ?

• Coupon bonds pay periodic interest (usually semiannually) throughout the bond's life
• Zero-coupon bonds pay no periodic interest; instead, they are sold at a deep discount to par value and the investor receives the full face value at maturity

Think of it this way: With a coupon bond, you get your money back gradually through interest payments. With a zero-coupon bond, all your return is locked up until maturity, so if rates change, the entire value of the bond swings with them.

Because a zero-coupon bond's duration equals its full maturity while a coupon bond's is always shorter, zeros carry the highest duration, and therefore the highest interest rate sensitivity, of any bond with the same maturity date.

How Does Duration Measure Interest Rate Risk?

Duration measures a bond's price sensitivity to changes in interest rates, expressed in years.

• Higher duration = greater price volatility when interest rates change
• Duration tells you approximately how much a bond's price will change for a 1% change in interest rates

Key duration rules:

• A zero-coupon bond's duration equals its maturity (all cash flow comes at the end)
• A coupon-paying bond's duration is always less than its maturity (earlier cash flows reduce duration)
• Higher coupon rate → lower duration → less interest rate sensitivity
• Longer maturity → higher duration → more interest rate sensitivity
• Higher yield → slightly lower duration

Quick example: A bond with a duration of 5 years will lose approximately 5% of its value if interest rates rise by 1%. If rates fall by 1%, it gains approximately 5%.

Exam Tip: Gotchas

Duration is not the same as maturity. A 10-year bond paying a 6% coupon has a duration well below 10 years. Only zero-coupon bonds have duration equal to maturity. The exam loves testing this distinction.

Why Do Bonds Trade Above or Below Par?

A bond's market price relative to its par value (usually $1,000) tells you about the relationship between its coupon rate and the current market yield.

• If a bond pays a 5% coupon but the market only requires 3%, investors bid the price above par to capture that extra income. The bond trades at a premium
• If the market requires 7% but the bond only pays 5%, the price drops below par to make the total return competitive. The bond trades at a discount
• As bonds approach maturity, their prices converge toward par value. This is called pull to par

Think of it this way: A premium bond is like buying a car with an above-market warranty; you pay extra up front for the better deal. A discount bond is like buying a slightly outdated model at a lower price.

What Should You Check on Exam Day?

• Match each bond type to its tax treatment: corporate (fully taxable), Treasury (federal taxable, state/local exempt), municipal (generally federal exempt, potentially triple tax-exempt if home-state); the muni exemption covers interest only, and capital gains on any bond stay taxable.
• Explain why a municipal bond is unsuitable inside a traditional IRA, a Roth IRA, a pension plan, or a charitable foundation.
• Rank liquidity from most to least liquid: Treasuries, agencies, investment-grade corporates, municipals, high-yield corporates; and rank liquidation priority: secured bonds, unsecured debentures, subordinated debentures, preferred stock, common stock.
• Know that callable bonds carry higher yields to compensate for call risk, and that issuers call bonds when rates fall.
• Confirm duration equals maturity only for zero-coupon bonds (coupon-paying bonds always have duration less than maturity), and that premium means coupon rate above market yield (price above par) while discount means the reverse.