Synthesis

Quick Answer

Work fixed income exam questions in order: find the price relationship (premium, discount, or par), pick the right yield (YTC for a premium callable bond likely to be called, YTM for discount), assess risk (duration, credit rating, spread, call features, maturity), then factor in special features like convertibility or a zero coupon.

This four-step sequence prevents the most common exam error: picking a yield or risk answer before establishing whether the bond trades at a premium or discount in the first place.

Step 1: Determine Price Relationship

If You Know Yield to Maturity (YTM) > Coupon, Then Bond is at discount

If You Know YTM < Coupon, Then Bond is at premium

If You Know YTM = Coupon, Then Bond is at par

If You Know Current Yield (CY) > Coupon, Then Bond is at discount

If You Know CY < Coupon, Then Bond is at premium

Step 2: Apply the Appropriate Yield

Discount: Focus On YTM (issuer will not call)

Premium, callable, likely to be called: Focus On Yield to Call (YTC), since it trades above the call price

Premium, not callable (or not likely to be called): Focus On YTM; there is no YTC on a noncallable bond

Par: Focus On Nominal yield, current yield, and YTM are equal; calculate YTC separately if callable

Step 3: Assess Risk Profile

Duration: Key Question How sensitive is this bond to rate changes?

Credit rating: Key Question How likely is default?

Credit spread: Key Question How much extra yield for the credit risk?

Call features: Key Question Could reinvestment risk materialize?

Maturity: Key Question How long is the investor exposed?

Step 4: Consider Special Features

Callable: Key Consideration Reinvestment risk; YTC most relevant for a premium bond likely to be called; use effective duration

Puttable: Key Consideration Benefits bondholder when rates rise; lower coupon than comparable bonds

Convertible: Key Consideration Use par value for conversion ratio; trades at greater of bond value or conversion value

Zero-coupon: Key Consideration No reinvestment risk but highest volatility; phantom income tax; best for tax-deferred accounts

The Master Yield Ranking

Discount: Nominal < CY < YTM < YTC

Premium: Nominal > CY > YTM > YTC

Par: Nominal = CY = YTM

Key Formulas

Current Yield = Annual Interest divided by Market Price

Taxable Equivalent Yield (TEY) = Tax-exempt Yield divided by (1 - Marginal Tax Rate)

Conversion Ratio = Par Value divided by Conversion Price

Conversion Value = Conversion Ratio x Stock Price

Credit Spread = Corporate Bond Yield - Treasury Yield

Price Change approximately = -Duration x Change in Yield

Exam Tip: Gotchas

Yield to Worst (YTW) is always the LOWEST possible yield: the most conservative measure. It is the lesser of YTM, YTC, or any yield to a put date.

Discounted Cash Flow (DCF) value > market price means undervalued (buy). DCF value < market price means overvalued (sell).

What Should You Check on Exam Day?

Work the four steps in order: price relationship, then yield, then risk, then special features. Do not jump straight to a yield answer.

Confirm the yield ranking direction matches the price relationship you found in Step 1: discount climbs, premium dips.

Double-check that a callable or puttable feature does not change which yield or which duration measure applies.