1.4 Bond Yield, Tax & Suitability
This chapter covers how bond returns are measured, taxed and judged for suitability. It starts with the four yields and their order, moves through duration and the time value of money, and then turns to municipal tax exemption and the risks a bond investor faces. Exam questions lean on relationships, such as which yield is higher or which bond moves more, more than on arithmetic, and advisers use the same ideas to decide whether a bond fits a client’s tax bracket, age and income needs.
What each topic covers
Nominal, Current, YTM & YTC defines nominal yield as the coupon rate, annual income divided by par, which never changes. Current yield divides annual income by market price, so it sits above the coupon on a discount bond and below it on a premium bond, but it ignores time. YTM and YTC do account for time. For a 10-year, $1,000 par, 4% bond, the lesson gets a current yield of 5% and a YTM of 6.7% at $800, against 3.6% and 2.9% at $1,100. YTC applies only to callable bonds and gives 8.9% and 1.9% when the bond is callable at par after 5 years. A bond that “trades on a 7% basis” has a 7% YTM.
Discount, Par & Premium Yield Order gives the ranking the exam tests most. On a discount bond, yields run from lowest to highest: coupon, current yield, YTM, then YTC. A premium bond is the exact mirror image, with YTC lowest and the coupon highest, and at par every yield equals the coupon. The lesson presents this as the bond see-saw and the “CYM Call” memory aid, and notes that the exam stresses whether one yield is higher than another more than computing each from scratch.
Duration & Price Volatility explains that longer maturities and lower coupons produce the most price volatility and the longest duration, using a 1-year versus a 20-year bond and a 2% versus a 10% coupon. Duration measures price sensitivity to rate changes and the time needed to recoup the original cost. A 20-year, $1,000 par, 10% debenture quoted at 120 ($1,200) and paying $100 a year has a duration of roughly 12 years. A zero coupon bond’s duration equals its maturity, so two bonds with the same maturity can have very different durations.
Time Value & Discounted Cash Flow starts from opportunity cost: a dollar today is worth more than a dollar later because it can be invested now. It gives the present value formula, PV = FV ÷ (1 + DR)ⁿ, where the discount rate is the market’s average rate of return. The worked example discounts a $1,000 par, 2-year, 5% debenture quoted at 97 at a 6% market rate, giving $47.17 plus $934.50, or $981.67, to compare against the $970 price. It closes with a lottery example comparing a lump sum with 30 years of installments.
Municipal Tax Exemption & TFEY shows that bond taxation depends on the issuer. Corporate interest is fully taxable, US government interest is federally taxable but exempt from state and local tax, and municipal interest is federally exempt and fully tax-free to a resident of the issuing state. US territory bonds are always tax-free regardless of residence, and the alternative minimum tax can make private activity bond interest taxable. The tax-free equivalent yield formula is TFEY = CY x (100% - TB). At a 37% bracket a 7% corporate bond yields 4.4% after tax, so a 5% municipal bond pays more. At a 25% bracket the same corporate bond yields 5.25%, so it beats the municipal. Municipal bonds are also unsuitable for retirement plans such as IRAs.
Bond Risk & Investor Profile lists the benefits of bonds: interest is a legal obligation of the issuer and needs no board approval, which makes income more predictable than dividends. Systematic risks are interest rate risk and purchasing power risk. Non-systematic risks include default, liquidity, legislative, political, reinvestment and call risk, with call risk the worst form of reinvestment risk. Ratings from S&P, Moody’s and Fitch separate investment grade (BBB or Baa and higher) from speculative bonds (BB or Ba and lower). The typical bond investor is older and more conservative, and the Rule of 100 says age roughly matches the bond percentage.