Corporate Bond
Corporate Bond
Debt securities issued by corporations to raise capital, representing a loan from investors to the company. Corporate bonds carry higher credit risk than government bonds but typically offer higher yields to compensate. Bonds are rated investment-grade (BBB-/Baa3 or higher) or high-yield/junk (below investment-grade), with interest income taxable at ordinary income rates.
A tech company issues 10-year corporate bonds with a 5% coupon rate. An investor purchases $10,000 face value, receiving $500 annual interest ($250 semi-annually). If the company faces financial difficulties, the bond rating may drop from BBB (investment-grade) to BB (high-yield), causing the market price to fall even though coupon payments continue.
Students often confuse corporate bonds with government bonds (assuming same safety level), misunderstand the inverse relationship between bond prices and yields, or forget that higher-rated bonds (AAA) pay lower yields than lower-rated bonds (BB) due to lower risk.
How This Is Tested
- Identifying appropriate corporate bond investments based on client risk tolerance and credit ratings
- Understanding the inverse relationship between bond prices and market interest rates
- Comparing yields and credit risk between investment-grade and high-yield corporate bonds
- Calculating yield-to-maturity or current yield for corporate bond investments
- Determining tax implications of corporate bond interest versus municipal bond interest
Regulatory Limits
| Description | Limit | Notes |
|---|---|---|
| Investment-grade threshold | BBB-/Baa3 or higher | S&P/Fitch use BBB-, Moody's uses Baa3 as lowest investment-grade rating |
| High-yield (junk bond) threshold | BB+/Ba1 or lower | Below investment-grade, carries significantly higher default risk |
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Marcus, age 58, is a conservative investor seeking stable income for retirement in 7 years. He is in the 32% federal tax bracket. His portfolio currently consists of 60% large-cap stocks and 40% money market funds. He wants to add fixed-income securities but is concerned about losing principal. Which of the following would be the most appropriate recommendation?
B is correct. Investment-grade corporate bonds rated A align with Marcus's conservative risk profile and 7-year time horizon. The A rating indicates strong creditworthiness (well above investment-grade threshold), and the 5-7 year maturity matches his retirement timeline, reducing interest rate risk. The 4.5% yield provides stable income superior to money market funds.
A is inappropriate because BB-rated bonds are high-yield (junk) bonds with elevated default risk, contradicting his conservative profile and principal preservation concern. C exposes Marcus to significant interest rate risk with the 25-year maturity, which doesn't match his 7-year horizon. D carries extreme credit risk with unrated bonds, making it completely unsuitable for a conservative investor concerned about losing principal.
The Series 65 exam frequently tests suitability of corporate bond investments based on credit ratings, time horizons, and client risk tolerance. Understanding the distinction between investment-grade and high-yield bonds is critical for making appropriate recommendations.
What is the minimum credit rating threshold for a corporate bond to be classified as investment-grade by Standard & Poor's?
B is correct. BBB- is the lowest investment-grade rating from Standard & Poor's and Fitch. Bonds rated BBB- or higher are considered investment-grade, meaning they have adequate capacity to meet financial commitments but may be more vulnerable to adverse economic conditions than higher-rated bonds.
A (A-) is investment-grade but not the minimum threshold; it's three notches higher than BBB-. C (BB+) is the highest high-yield (junk) rating, falling one notch below investment-grade. D (B+) is a lower high-yield rating, indicating heightened default risk and speculative characteristics. The distinction between BBB- and BB+ represents the critical boundary between investment-grade and speculative-grade debt.
The Series 65 exam tests knowledge of credit rating scales and the investment-grade threshold. Many institutional investors and fiduciaries have mandates restricting them to investment-grade securities only, making this distinction critical for portfolio management and suitability.
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C is correct. Current yield = (Annual coupon payment / Current market price) × 100. Calculate: Annual coupon = $1,000 × 6% = $60. Current yield = ($60 / $950) × 100 = 6.32%. Because the bond trades below par (at a discount), the current yield exceeds the stated coupon rate.
A (5.70%) incorrectly uses the formula backwards ($950 × 6% / $1,000). B (6.00%) is the stated coupon rate, not the current yield; current yield adjusts for the bond trading at a discount. D (6.84%) incorrectly calculates based on $1,000 face value divided by $950, which is not the current yield formula. When bonds trade at a discount (below $1,000), current yield will always exceed the coupon rate.
Current yield calculations appear frequently on the Series 65 exam. Understanding that current yield adjusts the coupon rate based on market price is essential for comparing bond investments and explaining yields to clients. Remember: bonds trading at discounts have current yields higher than coupon rates.
All of the following statements about corporate bonds are accurate EXCEPT
D is correct (the EXCEPT answer). Corporate bonds do NOT always offer lower yields than Treasury bonds; in fact, corporate bonds typically offer HIGHER yields than comparable Treasury bonds to compensate investors for additional credit risk. This yield spread (credit spread) widens as credit quality decreases.
A is accurate: corporate bond interest is fully taxable at all levels (federal, state, and local), unlike municipal bonds which offer tax advantages. B is accurate: bond prices and interest rates have an inverse relationship; when rates rise, existing bond prices fall, and vice versa. C is accurate: investment-grade bonds (BBB-/Baa3 and above) have lower default risk than high-yield bonds (BB+/Ba1 and below), which is why they pay lower yields.
The Series 65 exam tests your understanding of fundamental bond relationships and risk-return tradeoffs. Corporate bonds must offer higher yields than risk-free Treasuries to attract investors willing to accept credit risk. This concept is central to fixed-income portfolio construction and client education.
A corporate bond is downgraded from BBB to BB by Standard & Poor's. Which of the following effects would this downgrade most likely cause?
1. The bond's market price would increase
2. The bond's yield would increase
3. The bond would move from investment-grade to high-yield status
4. The bond's coupon payment amount would change
B is correct. Statements 2 and 3 are accurate.
Statement 1 is FALSE: A credit downgrade causes the bond's market price to DECREASE, not increase. Lower credit quality means higher perceived risk, reducing the bond's value in the secondary market.
Statement 2 is TRUE: As the price decreases, the yield increases (inverse relationship). Investors demand higher yields to compensate for increased default risk.
Statement 3 is TRUE: BBB is the lowest investment-grade rating, while BB is the highest high-yield (junk) rating. This downgrade crosses the critical threshold from investment-grade to speculative-grade.
Statement 4 is FALSE: The coupon payment is fixed at issuance and does not change due to rating changes. Only the market price and yield adjust; the issuer continues paying the same dollar coupon amount.
The Series 65 exam tests understanding of how credit rating changes affect bond pricing and classifications. Downgrades across the investment-grade threshold can trigger forced selling by institutions restricted to investment-grade securities, amplifying price declines. Understanding these dynamics is critical for managing fixed-income portfolios.
💡 Memory Aid
Think of corporate bonds like lending money to a company with a credit card: The better the company's credit rating (AAA = excellent, BBB = okay, BB = risky), the lower the interest they pay you. Triple-B = Break Point (BBB- is the last stop before junk). When interest rates rise, your bond's value falls (inverse relationship). Unlike tax-free municipal bonds, corporate bond interest is fully taxable (ordinary income).
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