Master Element 2 of the RSE exam covering fixed income securities. Learn bond pricing mechanics, duration, yield calculations, Government of Canada bonds, corporate bonds, and preferred shares.
RSE Exam Element 2: Fixed Income (~8%, 10 Questions)
While this section has lower weight than Element 1, the concepts here are foundational for Element 5 (Mutual Funds) and Element 6 (Portfolio Construction). Understanding the math conceptually is more important than memorizing complex formulas.
Bond Pricing Mechanics - The Teeter-Totter
There is an inverse relationship between interest rates and bond prices:
- If market interest rates rise, existing bond prices fall (because new bonds pay more, making old ones less valuable)
- If market interest rates fall, existing bond prices rise
Premium vs. Discount
| Scenario | Condition | Price |
|---|---|---|
| Par | Coupon Rate = Market Yield | 100 |
| Discount | Coupon Rate < Market Yield | < 100 (buy cheap, pays less) |
| Premium | Coupon Rate > Market Yield | > 100 (pay extra, pays more) |
Yield Calculations
Current Yield
A snapshot of return based on cash flow only.
Calculation: Annual Coupon ($) ÷ Current Market Price ($)
Exam Note: It does NOT account for capital gains or losses at maturity.
Yield to Maturity (YTM)
The total return anticipated if the bond is held until it matures.
Components:
- Coupon Income
- Interest on Interest (reinvestment)
- Capital Gain/Loss (difference between purchase price and Par)
This is the standard measure used to compare bonds.
Duration - Understanding Interest Rate Sensitivity
Definition: A measure of a bond's price sensitivity to interest rate changes (expressed in years).
Duration Rules:
- Higher Duration = Higher Volatility
- Longer Maturity = Higher Duration
- Lower Coupon = Higher Duration (you wait longer to get your money back)
Duration Rule for Price Changes
Formula: Price Change ≈ -Duration × Change in Yield
Example: If Duration is 7 years and interest rates rise by 1%, the bond price drops by approximately 7%.
Government Securities
Government of Canada Bonds (GOC)
- Characteristics: Non-callable, effectively risk-free (no default risk), highly liquid
- Income: Pays interest semi-annually. Taxed as fully taxable interest income
Treasury Bills (T-Bills)
- Structure: Short-term (< 1 year) debt. Sold at a discount and mature at Par (100). No coupons.
- Taxation: The difference between issue price and par is taxed as Interest Income, not Capital Gains
Corporate Bonds & Features
Security (Collateral)
- Mortgage Bond: Secured by real assets (land, buildings). Safer.
- Debenture: Secured only by the "general credit" (promise to pay) of the company. Riskier.
Credit Ratings
- Investment Grade: BBB- (Standard & Poor's) or higher. Suitable for conservative accounts.
- High Yield (Junk): BB+ or lower. Higher risk of default, higher yield.
Callable Bonds (Issuer's Choice)
- Feature: Issuer can pay off the bond early
- Risk: They will only call it when interest rates fall (to refinance cheaper). This hurts the investor (Reinvestment Risk). Therefore, callable bonds pay a higher yield.
Preferred Shares - The Hybrid
Legally equity, but acts like fixed income (fixed dividend).
- Priority: Rank below bonds but above common stock in bankruptcy
- Types: Perpetual (no maturity), Rate Reset (adjusts every 5 years), Cumulative (missed dividends must be paid)
- Taxation: Dividends from Canadian corporations are eligible for the Dividend Tax Credit - much higher after-tax yield than interest income
Fixed Income Risks
- Interest Rate Risk: Rising rates lower bond prices (highest in long-term, low-coupon bonds)
- Reinvestment Risk: Reinvesting payments at lower rates (highest when rates fall)
- Inflation Risk: Inflation erodes purchasing power of fixed cash flows
- Liquidity Risk: Difficulty selling quickly at fair price
Bond Ladders Strategy
Strategy: Buying bonds with staggered maturities (e.g., 1yr, 2yr, 3yr, 4yr, 5yr)
Benefit: Reduces interest rate risk. If rates rise, short-term bonds mature and can be reinvested at higher rates. If rates fall, long-term bonds lock in higher yields.
RSE Exam Tips for Fixed Income
- Remember: Interest rates UP = Bond prices DOWN
- Duration measures price sensitivity to rate changes
- T-Bill gains are taxed as interest income, not capital gains
- Callable bonds benefit the issuer, not the investor
- Preferred share dividends get the Dividend Tax Credit advantage