Characteristics Affecting Valuation

Before diving into yield calculations and valuation models, you need to understand the features that make bonds different from one another. These characteristics directly affect a bond's price, risk, and attractiveness to investors.

Tax Implications

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.

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.

Market Liquidity

• 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

Liquidation Preference

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.

Call Features

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 coupon rates 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

Coupon vs. Zero-Coupon Bonds

• 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.

Duration

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.

Premium vs. Discount Bonds

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.