Fixed-Income Instrument Types

Why Fixed-Income Instrument Types Matter for the CTP Exam

Fixed-income instruments sit at the heart of the Capital Structure and Long-Term Capital domain of the AFP Certified Treasury Professional (CTP) exam. A treasury professional must understand these instruments from two angles: as an issuer raising long-term debt capital to fund the firm, and as an investor deploying excess cash into securities that preserve principal and generate yield. Debt is usually the cheapest component of a company's capital structure because interest is tax-deductible, so choosing the right instrument directly affects the weighted average cost of capital (WACC), financial flexibility, credit rating, and liquidity risk. On the exam, this topic appears in questions about selecting financing alternatives, evaluating covenants and call features, interpreting credit ratings, comparing yields, and managing interest-rate exposure. Expect roughly several questions that either name an instrument and ask for its defining feature, or describe a situation and ask which instrument fits best.

What Is a Fixed-Income Instrument?

A fixed-income instrument is a debt contract in which a borrower (the issuer) promises to make specified payments of interest (the coupon) and to repay principal (par or face value) at maturity. The term fixed-income is used broadly even though some instruments carry floating coupons or no coupon at all. Key structural features that define every fixed-income security include:

• Par (face) value: the amount repaid at maturity, typically $1,000 per bond in the United States.
• Coupon rate: the stated annual interest rate applied to par, usually paid semiannually in the U.S.
• Maturity: the date principal is repaid. Short-term is generally under one year, intermediate is roughly 1 to 10 years, and long-term exceeds 10 years.
• Yield: the return an investor actually earns, which differs from the coupon when the bond trades at a premium or discount.
• Seniority and security: where the holder stands in bankruptcy and whether specific collateral backs the obligation.
• Embedded options: call, put, or conversion features that shift risk between issuer and investor.
• Indenture: the legal contract specifying terms, covenants, and the role of the trustee who represents bondholders.

Major Categories of Fixed-Income Instruments

1. U.S. Treasury Securities
Issued by the federal government and considered free of default risk, Treasuries serve as the benchmark for pricing all other dollar-denominated debt.
• Treasury bills (T-bills): maturities of one year or less, sold at a discount with no coupon; the return is the difference between purchase price and par.
• Treasury notes: maturities of 2 to 10 years with semiannual coupons.
• Treasury bonds: maturities of 20 or 30 years with semiannual coupons.
• TIPS (Treasury Inflation-Protected Securities): principal adjusts with the Consumer Price Index, protecting real purchasing power.
• STRIPS: zero-coupon instruments created by separating coupon and principal payments of Treasury notes and bonds.

2. Federal Agency and Government-Sponsored Enterprise (GSE) Securities
Issued by entities such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. These carry an implicit (not explicit) government guarantee in most cases, so they yield slightly more than Treasuries. Ginnie Mae securities, by contrast, carry the full faith and credit of the U.S. government.

3. Municipal Bonds
Issued by states, cities, and other local authorities. Interest is generally exempt from federal income tax and often from state tax for in-state residents, so nominal yields are lower than comparable taxable bonds. Two main types:
• General obligation (GO) bonds: backed by the full taxing power of the issuer.
• Revenue bonds: repaid only from the cash flows of a specific project such as a toll road or utility, making them riskier than GO bonds.
To compare a muni with a taxable bond, compute the taxable-equivalent yield: tax-exempt yield divided by (1 minus marginal tax rate).

4. Corporate Bonds
Issued by companies to fund long-term needs. These are the instruments a corporate treasurer is most likely to issue. Classification by security and seniority:
• Mortgage bonds: secured by a lien on real property such as plants or land.
• Equipment trust certificates: secured by specific equipment, commonly used by airlines and railroads; title stays with a trustee until the debt is repaid.
• Collateral trust bonds: secured by financial assets (stocks or bonds of other companies) pledged by the issuer.
• Debentures: unsecured bonds backed only by the general creditworthiness of the issuer; most investment-grade corporate bonds are debentures.
• Subordinated debentures: unsecured and junior to other debt in bankruptcy; they carry higher coupons to compensate for added risk.
• Income bonds: pay interest only if the issuer earns sufficient income; rare and usually arise from reorganizations.

5. Bonds Classified by Coupon Structure
• Fixed-rate bonds: constant coupon for the life of the bond; the issuer bears the risk that rates fall and the investor bears the risk that rates rise.
• Floating-rate notes (FRNs): coupon resets periodically based on a reference rate such as SOFR plus a spread; price stays near par, so interest-rate price risk is low but income is uncertain.
• Zero-coupon bonds: sold at a deep discount and pay no periodic interest; the investor receives par at maturity. Zeros have the greatest price sensitivity to rate changes for a given maturity (duration equals maturity). Issuers may deduct imputed interest annually even though no cash is paid, while taxable investors owe tax on phantom income.
• Step-up bonds: coupon increases on a set schedule or upon a ratings downgrade.
• Payment-in-kind (PIK) bonds: pay interest in additional bonds rather than cash, used by highly leveraged issuers.

6. Bonds Classified by Embedded Options
• Callable bonds: the issuer may redeem before maturity, usually after a call-protection period and often at a premium to par. Calls benefit the issuer when rates fall, so investors demand a higher yield. Yield-to-call is relevant when a bond trades above par.
• Putable bonds: the investor may sell the bond back to the issuer at par on specified dates. This protects investors from rising rates or deteriorating credit, so putable bonds carry lower yields.
• Convertible bonds: may be exchanged for a fixed number of common shares. The conversion ratio equals par divided by the conversion price. Convertibles carry lower coupons because investors value the equity upside; issuers accept potential dilution in exchange for cheaper financing.
• Sinking-fund bonds: the issuer retires a portion of the issue each year, either by purchasing bonds in the market or calling them by lottery. This reduces default risk at maturity and shortens average life.

7. High-Yield (Junk) Bonds
Rated below investment grade (below BBB- by S&P and Fitch or below Baa3 by Moody's). They offer higher coupons to compensate for greater default risk and often carry more restrictive covenants and call features. Fallen angels are bonds downgraded from investment grade; rising stars move in the opposite direction.

8. Asset-Backed and Mortgage-Backed Securities
• Mortgage-backed securities (MBS): pass-through securities backed by pools of residential or commercial mortgages. Investors face prepayment risk: when rates fall, homeowners refinance and principal returns early, forcing reinvestment at lower yields.
• Collateralized mortgage obligations (CMOs): redistribute MBS cash flows into tranches with different maturities and prepayment exposures.
• Asset-backed securities (ABS): backed by receivables such as auto loans, credit card balances, student loans, or equipment leases. Companies use securitization to convert illiquid receivables into immediate cash and move assets off the balance sheet.

9. Medium-Term Notes (MTNs)
Corporate debt offered continuously through dealers under a shelf registration, with maturities commonly from 9 months to 30 years. MTNs let a treasurer tap the market in small amounts whenever conditions are favorable and tailor maturities to specific funding needs.

10. International Bonds
• Eurobonds: issued outside the jurisdiction of the currency in which they are denominated (for example, a U.S. dollar bond sold in London). Typically bearer form, annual coupons, and lighter regulation.
• Foreign bonds: issued in a domestic market by a foreign issuer in that market's currency; Yankee bonds (U.S.), Samurai bonds (Japan), and Bulldog bonds (U.K.).
• Global bonds: issued simultaneously in several markets.

11. Private Placements Versus Public Issues
Private placements are sold directly to a small group of institutional investors (often insurance companies) under SEC Rule 144A or Regulation D, avoiding registration costs and allowing customized covenants, but with less liquidity and often higher yields. Public issues are registered with the SEC, underwritten by investment banks, and trade in secondary markets.

12. Hybrid and Related Instruments
• Preferred stock: legally equity but behaves like a perpetual fixed-income instrument with a stated dividend; dividends are not tax-deductible for the issuer, though corporate investors receive a dividends-received deduction.
• Perpetual bonds: no maturity date; the issuer pays coupons indefinitely.
• Term loans: bank debt with scheduled amortization; not securities but a key long-term debt alternative on the exam.

How Fixed-Income Instruments Work: Pricing, Yield, and Risk

Price and yield move inversely. A bond's price equals the present value of its coupons and principal discounted at the market yield. If market rates rise above the coupon, the bond trades at a discount; if rates fall below the coupon, it trades at a premium. Longer maturities and lower coupons mean greater price sensitivity, which is measured by duration.

Yield measures:
• Nominal (coupon) yield = annual coupon / par.
• Current yield = annual coupon / current market price.
• Yield to maturity (YTM) = the discount rate equating price with all future cash flows; assumes the bond is held to maturity and coupons are reinvested at that rate.
• Yield to call (YTC) = the same calculation assuming the bond is called on the first call date at the call price.
• Yield to worst = the lowest of YTM and all YTCs.

Credit ratings from S&P, Moody's, and Fitch summarize default risk. Investment grade runs from AAA/Aaa down to BBB-/Baa3; anything lower is speculative grade. Ratings drive the credit spread over Treasuries, and many institutional investors are restricted to investment-grade paper, so a downgrade below that line can sharply raise borrowing costs.

Covenants protect bondholders. Affirmative covenants require actions (maintain insurance, deliver financial statements, keep ratios above thresholds). Negative covenants restrict actions (limit additional debt, dividends, asset sales, or liens). A negative pledge clause prevents the issuer from pledging assets to other lenders.

Key risks you must associate with each instrument:
• Interest-rate (price) risk: highest for long-term, low-coupon, and zero-coupon bonds; lowest for FRNs and short maturities.
• Reinvestment risk: highest for high-coupon callable bonds and MBS; zero for zero-coupon bonds held to maturity.
• Credit (default) risk: lowest for Treasuries, highest for subordinated and high-yield debt.
• Call or prepayment risk: callable bonds and MBS.
• Liquidity risk: private placements, small issues, and exotic structures.
• Inflation risk: fixed-coupon bonds; mitigated by TIPS and FRNs.
• Currency risk: foreign-currency bonds.

The Treasurer's Perspective: Choosing an Instrument

When the exam frames a question from the issuer's viewpoint, think about these trade-offs:
• Fixed versus floating: lock in costs if rates are expected to rise; float if rates are expected to fall or to match floating-rate assets.
• Secured versus unsecured: pledging collateral lowers the coupon but reduces future flexibility.
• Callable: pays a higher coupon but preserves the ability to refinance if rates fall.
• Convertible: lowers the coupon and may be attractive when equity is expected to appreciate, at the cost of potential dilution.
• Public versus private: public lowers yield and improves liquidity but adds registration cost and disclosure; private offers speed and flexibility.
• Maturity matching: finance long-lived assets with long-term debt to avoid refinancing risk.

How to Answer Exam Questions on Fixed-Income Instrument Types

Step 1: Identify the perspective. Is the question asking what the issuer wants or what the investor wants? Features that help one side (a call provision helps the issuer) hurt the other and show up as a higher or lower yield.

Step 2: Spot the defining keyword. Each instrument has a signature word. Lien on real property signals mortgage bond. Unsecured means debenture. Junior means subordinated. Exchange for shares means convertible. Issuer may redeem means callable. Holder may sell back means putable. Principal indexed to CPI means TIPS. Sold at a discount with no coupon means zero or T-bill. Pool of mortgages with early principal return means MBS and prepayment risk. Continuous offering under shelf registration means MTN. Issued outside the currency's home country means Eurobond. Backed by taxing power means GO bond; backed by project cash flows means revenue bond.

Step 3: Apply the inverse relationship. If a question describes rates rising, prices fall; the bond most affected is the one with the longest duration (long maturity, low or zero coupon). If rates fall, callable bonds and MBS get called or prepaid, creating reinvestment risk.

Step 4: Rank by risk and yield consistently. In bankruptcy priority: secured debt, then senior unsecured (debentures), then subordinated debentures, then preferred stock, then common stock. Yields rise in the same order. Treasuries yield less than agencies, which yield less than investment-grade corporates, which yield less than high-yield bonds.

Step 5: Do the simple math carefully. Common calculations include taxable-equivalent yield, current yield, conversion ratio and conversion value, after-tax cost of debt (pre-tax rate times one minus the tax rate), and the bond price direction given a coupon versus market rate comparison. Read whether coupons are annual or semiannual and whether the tax rate given is marginal.

Step 6: Eliminate distractors. Wrong answers often swap issuer and investor benefits, confuse GO and revenue bonds, confuse Eurobonds and foreign bonds, or attach prepayment risk to the wrong instrument. Cross out any choice that contradicts the inverse price-yield rule or the seniority ladder.

Exam Tips: Answering Questions on Fixed-Income Instrument Types

• Memorize the seniority ladder and recite it before the exam: mortgage bonds and other secured debt, senior debentures, subordinated debentures, preferred, common. Nearly every question about risk or required yield resolves on this ordering.
• Link each embedded option to who benefits. Call = issuer benefit = higher coupon. Put = investor benefit = lower coupon. Conversion = investor benefit = lower coupon. If an answer choice reverses these, it is wrong.
• Zero-coupon bonds are a favorite. Remember: no reinvestment risk if held to maturity, maximum price volatility for a given maturity, duration equals maturity, and phantom taxable income for holders.
• Know the investment-grade cutoff cold: BBB- (S&P and Fitch) and Baa3 (Moody's). Questions about losing access to certain investors or covenant triggers often hinge on this line.
• Treasuries are the benchmark, not risk-free in every sense. They have no default risk but still carry interest-rate, reinvestment, and inflation risk. A question asking which risk a Treasury bond lacks is looking for default or credit risk.
• Municipal yield comparisons require the taxable-equivalent formula. Divide the muni yield by (1 minus the tax rate); never multiply.
• MBS equals prepayment risk. Whenever you see mortgage pools, falling rates, or refinancing, the tested concept is prepayment and the resulting reinvestment risk.
• Floating-rate notes have low price risk but variable income. If a question asks which instrument keeps its market value stable when rates change, pick the FRN or the shortest-maturity instrument.
• Eurobond versus foreign bond: the Eurobond is defined by being sold outside the country of its currency, not by Europe. A Yankee bond is a foreign bond issued in the U.S. in dollars by a non-U.S. issuer.
• Watch for the word unsecured. It always points to debentures, and if combined with junior or lower priority, to subordinated debentures.
• From the issuer's chair, think WACC. Interest is tax-deductible so the after-tax cost of debt is lower than the coupon; preferred dividends are not deductible. Questions on the cheapest source of long-term capital usually favor senior secured debt, while questions on flexibility favor unsecured or callable structures.
• Read the whole question stem. The CTP exam often buries the key fact (such as expected direction of interest rates or the firm's tax status) in the first sentence and then asks a seemingly generic question in the last sentence.
• Manage your time. Instrument-identification questions should take under a minute. Flag any calculation question that seems lengthy and return to it after securing the quick points.

Sample Question Walkthroughs

Question 1: A company wants to issue long-term debt at the lowest possible coupon and is willing to accept potential future dilution of existing shareholders. Which instrument is most appropriate?
Approach: Lowest coupon plus dilution points directly to the conversion feature. Answer: convertible bond. Distractors such as callable bonds (higher coupon) and subordinated debentures (higher coupon, no dilution) are eliminated by the keyword dilution.

Question 2: An investor holds a 30-year zero-coupon bond and a 30-year 8 percent coupon bond. Market rates fall by 1 percent. Which bond's price rises more and why?
Approach: Price sensitivity is driven by duration. The zero has duration equal to 30 years; the coupon bond's duration is much shorter because of interim cash flows. Answer: the zero-coupon bond rises more.

Question 3: A corporate treasurer invests short-term cash in a municipal note yielding 3 percent. The firm's marginal tax rate is 25 percent. What taxable yield is equivalent?
Approach: 3 percent divided by (1 minus 0.25) = 3 / 0.75 = 4 percent. Any taxable instrument yielding less than 4 percent is inferior on an after-tax basis.

Question 4: Which bondholder has the lowest priority claim in liquidation: holders of mortgage bonds, debentures, subordinated debentures, or equipment trust certificates?
Approach: Apply the seniority ladder. Mortgage bonds and equipment trust certificates are secured; debentures are senior unsecured; subordinated debentures are junior. Answer: subordinated debentures.

Question 5: A firm issues a bond whose coupon resets quarterly at SOFR plus 150 basis points. Which risk is minimized for the investor?
Approach: Floating coupons keep price near par as rates change. Answer: interest-rate (price) risk is minimized, though income variability and credit risk remain.

Final Review Checklist

Before exam day, confirm you can do each of the following without notes: define every instrument listed above in one sentence; state who benefits from each embedded option and the yield consequence; rank instruments by default risk and by interest-rate sensitivity; compute taxable-equivalent yield, current yield, conversion ratio, and after-tax cost of debt; explain the difference between GO and revenue bonds, Eurobonds and foreign bonds, MBS and ABS, and public issues and private placements; and recite the investment-grade cutoff and the seniority ladder. Mastery of these fundamentals converts a historically challenging section of the CTP exam into reliable points.