Fixed-Income Instrument Features

Fixed Income, LOS weight share 0.5 percent of the 365 Level I learning outcomes.

Fixed IncomeFixed-Income Instrument Features

The word call sounds like something the bondholder does, and the exam's whole trick on embedded options is that the issuer, not the investor, holds the phone.

Before you watch

Answer these three first. Getting them wrong now is normal, and it helps the lesson stick. Reveal the answers when you're done, then read on.

1. A bond indenture is best described as:

Answer: B. The indenture is the governing legal contract specifying the issuer's obligations and bondholders' rights, administered by a trustee. A call provision (choice C) may be one term written inside the indenture, but it is not the indenture itself; a yield spread (choice A) is unrelated.

2. A callable bond gives the option to redeem the bond early to:

Answer: B. A callable bond gives the issuer, not the bondholder, the right to redeem early, and the issuer exercises it when rates fall, refinancing at a lower rate, the same logic as a homeowner refinancing a mortgage. This is harmful to the investor, who loses the higher-coupon bond exactly when it was most valuable to keep.

3. Which of the following is an example of a negative covenant in a bond indenture?

Answer: C. Negative covenants restrict what the issuer can do; prohibiting new senior debt protects existing bondholders from subordination. Maintaining a ratio and providing audited statements are both affirmative covenants, things the issuer must do, not restrictions on action.

The lesson

Runtime 15 minutes 6 seconds, measured from the published video.

The reading

Five to ten minutes on this one unit: what the exam wants, the idea in plain words, then straight into the trap and the practice.

The exam wants you to describe the basic features common to every bond, describe coupon structures and how each changes where a bond's return comes from, describe seniority and the bankruptcy priority waterfall, and identify who holds an embedded option and when that side would exercise it.

A small, consistent set of features fully describes a plain bond: the issuer, maturity, par value, coupon rate and payment frequency, and the currency it is denominated in. The indenture is the legal contract that actually governs all of this, not the certificate or book-entry record that merely evidences ownership; every promise the issuer makes to bondholders lives in the indenture, including its covenants.

Coupon structure changes where a bond's return actually comes from. A fixed-rate bond pays the same coupon every period. A floating-rate note resets its coupon periodically to a reference rate plus a fixed spread, which keeps its price close to par since the coupon tracks the market rather than staying frozen at issuance. A zero-coupon bond pays no periodic interest at all; its entire return is the gap between a deep issue discount and the par value paid at maturity. That absence of coupon payments has a counterintuitive consequence worth remembering: with no interim cash flows to offset the terminal payment, a zero-coupon bond carries the highest interest rate sensitivity of any bond at the same maturity, not the lowest. An inflation-linked bond keeps its coupon rate fixed but adjusts the principal it is paid on to the inflation rate, so it is the principal that moves, never the stated coupon rate itself.

Seniority determines the order investors get paid if the issuer defaults, running from secured creditors at the top, down through senior unsecured, then subordinated creditors, then preferred equity, with common equity last in line. A bond's seniority ranking, stated in its own indenture, decides how much of a recovery its holders can expect relative to every other claim on the same issuer.

Covenants are the promises an issuer makes as a condition of borrowing, and they split into two grammatical forms the exam tests directly. Affirmative covenants require the issuer to do something: maintain insurance, provide audited financial statements, maintain a minimum coverage ratio. Negative covenants prohibit the issuer from doing something: issuing new debt senior to the existing bonds, selling a key asset. The words describe grammatical form only, not severity; a demanding affirmative covenant can be far more burdensome than a mild negative one.

Every embedded option belongs to whichever side benefits from exercising it, and that side alone decides when it gets used. A call option belongs to the issuer and gets exercised when rates fall, letting the issuer refinance more cheaply at the investor's direct expense. A put option belongs to the investor and gets exercised when rates rise, letting the investor sell the bond back at a set price rather than accept a depressed market price. A conversion option also belongs to the investor and gains value as the issuer's own stock price rises.

The trap

The word call sounds like something a bondholder does, but the issuer holds a callable bond's option, not the investor; the issuer calls the bond when rates fall, exactly the moment a holder most wants to keep collecting the old, higher coupon.

Learning outcomes covered by this module

Verbatim from the 2026 CFA Level I topic outline. Every practice question and key rule below is tagged to one of these where the stem and explanation make the match clear.

  1. describe the features of a fixed-income security
  2. describe the contents of a bond indenture and contrast affirmative and negative covenants

Key rules

Written from this module's own lesson and the 2026 CFA Level I topic outline, in teaching order, each tagged to the learning outcome it belongs to where that is clear.

LOS 01

Every fixed-income security is defined by a small, consistent set of features

Issuer, maturity, par (face) value, coupon rate and payment frequency, and currency of denomination are the basic features that fully describe a plain bond; on top of these, a specific bond may add a coupon structure (fixed, floating, zero-coupon, inflation-linked), a seniority ranking, and one or more embedded options, each of which changes the bond's risk and value relative to a plain bond with the same maturity and par amount.

LOS 01

Coupon structure changes where the bond's return comes from

A fixed-rate bond pays a constant coupon each period; a floating-rate note resets its coupon periodically to a reference rate plus a fixed spread, which keeps its price close to par since the coupon tracks the market; a zero-coupon bond pays no periodic interest at all, delivering its entire return as the difference between a deep issue discount and par at maturity; an inflation-linked bond keeps a fixed coupon rate but applies it to a principal that itself adjusts with an inflation index, so both the coupon amount and the maturity redemption grow with inflation.

LOS 01

Seniority determines the order of payment if the issuer defaults, and it runs from secured debt down through equity

In a bankruptcy priority waterfall, secured creditors are paid first, then senior unsecured creditors, then subordinated (junior) creditors, then preferred equity, and common equity last; a bond's seniority ranking, stated in the indenture, determines where its claim falls in that order and therefore how much a holder can expect to recover if the issuer fails.

LOS 02

The indenture is the governing contract; affirmative covenants require action, negative covenants restrict it

The bond indenture is the full legal agreement between issuer and trustee specifying every term of the bond, including its covenants, promises the issuer makes as conditions of the borrowing. Affirmative covenants require the issuer to do something, maintain insurance, provide audited financial statements, maintain a minimum coverage ratio; negative covenants prohibit the issuer from doing something, issuing new debt senior to the existing bonds, paying dividends above a threshold, exceeding a leverage limit. The words affirmative and negative describe the grammatical form of the obligation, not its severity, a strict affirmative covenant can be more burdensome than a mild negative one.

LOS 02

Embedded options belong to whichever side benefits from exercising them

A call option belongs to the issuer and is exercised when rates fall, letting the issuer refinance more cheaply at the investor's expense; a put option belongs to the investor and is exercised when rates rise, letting the investor sell the bond back at a set price rather than accept a depressed market price; a conversion option belongs to the investor and gains value when the issuer's stock price rises above the conversion price, letting the investor exchange the bond for equity upside. Whoever holds the option decides when it is used, and the exam consistently tests whether a candidate can identify which side that is.

The trick

Authored only where a key rule has an arbitrary number, list, or formula shape worth a memory device; a module with none of those has no tricks here, on purpose.

Callable = issuer's phone. Putable = investor's phone

The party who holds the option is the party who decides when to use it. Callable bonds get called by the issuer; putable bonds get put by the investor.

Affirmative = must do. Negative = must not do

The words describe grammatical form, not harshness. A negative covenant is not automatically the more restrictive one.

Zero-coupon bonds carry the highest rate sensitivity of any bond at the same maturity

With no coupon cash flows to offset the terminal payment, a zero-coupon bond's entire value sits at maturity, making it maximally sensitive to changes in the discount rate compared to any coupon-paying bond of the same maturity.

The method

Authored, ordered steps for answering this module's question types; a calculation module's calculator-dependent step ends with a bracketed BA II Plus keystroke sequence.

  1. List a bond's basic features first: issuer, maturity, par value, coupon rate and frequency, currency.
  2. Identify the coupon structure: fixed, floating, zero-coupon, or inflation-linked, and how each changes where the bond's return comes from.
  3. Determine seniority and where the bond ranks in the bankruptcy priority waterfall.
  4. For a covenant question, classify it as affirmative (must do) or negative (must not do) based on the grammatical form of the obligation, not its perceived severity.
  5. For an embedded-option question, identify which side, issuer or investor, holds the option, then reason from that side's incentive to decide when it would be exercised.

One card

Condensed from the key rules and tricks above, nothing new. What you'd want on one index card the night before.

Practice questions

Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own explanation. 10 question(s) available for this unit.

Question 1Exam level

A bond indenture is most likely described as:

How sure are you?

Correct: A. The indenture (also called a trust deed) is the legal contract specifying the obligations of the issuer and the rights of bondholders. It is administered by a trustee. Option A is YTM (unrelated). Option C is a yield spread.
B. Option C is a yield spread.
C. Option C is a yield spread.

Unit: fixed-income-instrument-features

Question 2Exam level

Which of the following is most likely an example of a NEGATIVE covenant in a bond indenture?

How sure are you?

Correct: B. Negative covenants restrict what the issuer CAN DO. Prohibiting the issuance of senior debt protects existing bondholders from being subordinated. Options A, B, and D are all affirmative covenants. They specify things the issuer MUST DO (maintain ratios, make payments, provide disclosures). The exam consistently tests this affirmative = must do, negative = cannot do distinction.
A. Choosing A might seem logical if you think any obligation on the issuer qualifies as a negative covenant, but this is an affirmative covenant because it requires the issuer to take a specific action, which contrasts with the restrictive nature of a negative covenant like the correct answer.
C. You might find this option tempting because providing financial statements seems like a restriction on the issuer, but in reality, this is an affirmative covenant as it requires the issuer to take a specific action, which contrasts with the negative covenant in the correct answer that restricts the issuer from taking a specific action.

Unit: fixed-income-instrument-features

Question 3Exam level

A callable bond gives the option to call (redeem early) to, most likely:

How sure are you?

Correct: B. A callable bond gives the ISSUER the right to redeem the bond before maturity. The issuer calls when rates fall so they can refinance at a lower rate. Exactly as a homeowner refinances a mortgage. The call option is HARMFUL to the investor (their bond is called away when it's most valuable). The exam frequently tests who holds the option: callable = issuer holds it, putable = bondholder holds it.
A. This assigns the call option to the wrong party. A call option in a callable bond belongs to the issuer, not the bondholder, who has no say in whether the bond is redeemed early. When rates fall it is the issuer who benefits from calling the bond and refinancing at the new lower rate, while the bondholder actually loses out, their high-coupon bond gets taken away right when it is most valuable.
C. Choosing C might seem logical if you think the issuer would want to call the bond when rates rise to avoid higher interest payments, but this confuses the issuer's incentive; when rates rise, the issuer benefits from the existing lower rate and has no incentive to call the bond, as calling would mean issuing new debt at a higher rate.

Unit: fixed-income-instrument-features

Question 4Exam level

A putable bond is MOST likely to be exercised by the bondholder when:

How sure are you?

Correct: B. A put option gives the bondholder the right to sell the bond back to the issuer at par before maturity. When rates rise, the bond's market price falls below par. The bondholder exercises the put to sell at par rather than at the depressed market price. This is the mirror image of a call: callable bonds benefit the issuer when rates fall; putable bonds benefit the investor when rates rise.
A. You might think that improved credit quality makes the bond more valuable and thus more likely to be put, but in reality, improved credit quality reduces the likelihood of default, making the bond less risky and less likely to be put; instead, rising interest rates decrease the bond's market value below par, making the put option more attractive.
C. Choosing C might seem logical if you think a premium price indicates a favorable market condition, but remember, a putable bond's value to the holder lies in selling at par when the market price is below par, not above it, which makes exercising the put when the bond trades at a premium counterproductive.

Unit: fixed-income-instrument-features

Question 5Exam level

A zero-coupon bond is issued at $700 with a par value of $1,000 maturing in 5 years. The bondholder's return comes PRIMARILY from, most likely:

How sure are you?

Correct: A. Zero-coupon bonds pay NO periodic interest. They are issued at a deep discount and return par value at maturity. The entire return is the $300 capital appreciation ($1,000 - $700). Option A describes a coupon-paying bond's reinvestment return. Option C describes a floating-rate note. Zero-coupon bonds are important for duration calculations later: their Macaulay duration equals their maturity.
B. You might be thinking that any bond offers periodic payments, but floating rate notes, unlike zero-coupon bonds, provide regular interest payments based on a reference rate, which contradicts the zero-coupon bond's characteristic of having no intermediate payments.
C. You might be thinking of convertible bonds, which can be converted into equity shares, but a zero-coupon bond does not have this feature; its return comes from the difference between the purchase price and the par value at maturity, not from equity conversion.

Unit: fixed-income-instrument-features

Question 6Exam level

Which type of bond issuer is MOST likely to have its bonds considered free of default risk for analytical purposes?

How sure are you?

Correct: B. Sovereign governments issuing debt in their own currency are considered to have negligible default risk because they can theoretically print money to repay obligations. This is why US Treasuries, UK Gilts, and German Bunds serve as benchmark 'risk-free' rates. Supranational organizations (D) have very low but not zero risk. Municipal and corporate issuers carry credit risk. The CFA exam uses 'government bonds' as the benchmark for yield spreads (G-spread).
A. You might be tempted by the backing of a general obligation, thinking it provides a strong guarantee, but municipal bonds still carry credit risk and are not considered free of default risk like a sovereign government issuing debt in its own currency.
C. You might be tempted by the World Bank's strong financial position and global standing, but remember that even supranational organizations rely on member contributions and do not have the sovereign power to print money, unlike a government issuing debt in its own currency.

Unit: fixed-income-instrument-features

Question 7Exam level

A floating-rate note (FRN) with a reference rate of 3-month Euribor + 150 bps will most likely have its coupon reset:

How sure are you?

Correct: A. FRN coupons reset periodically. Usually every 90 days for a 3-month reference rate. Each reset, the new coupon equals the prevailing reference rate plus the fixed spread (150 bps here). This is critical for price behavior: FRNs trade close to par because their coupon adjusts with market rates, unlike fixed-rate bonds which fluctuate in price. Option C describes a cap provision (a feature that may exist but is not the standard reset mechanism).
B. Option C describes a cap provision (a feature that may exist but is not the standard reset mechanism).
C. Option C describes a cap provision (a feature that may exist but is not the standard reset mechanism).

Unit: fixed-income-instrument-features

Question 8Exam level

In the context of bond seniority, which of the following claims is most likely paid LAST in the event of issuer bankruptcy?

How sure are you?

Correct: C. The priority waterfall in bankruptcy: secured creditors first, then senior unsecured creditors, then subordinated creditors, then preferred equity, then common equity last. While preferred equity ranks above common equity, it is paid after ALL debt obligations. This is the capital structure priority concept. Preferred equity (D) is junior to all three bond categories listed.
A. You might be tempted to choose senior unsecured bondholders because they seem less secure than secured bondholders, but in the capital structure hierarchy, senior unsecured bondholders are still paid before preferred equity shareholders, making them not the last to be paid.
B. You might be tempted to choose subordinated bondholders because they seem less secure than senior bondholders, but remember that all bondholders, including subordinated ones, have priority over equity holders like preferred shareholders in the capital structure.

Unit: fixed-income-instrument-features

Question 9Above the exam

A bond has an embedded call option AND a step-up coupon feature (the coupon rate increases on specified future dates). Combining how each feature separately affects a bond's value to the investor, compared to an otherwise identical option-free, fixed-coupon bond, this bond's value to the investor is most likely:

How sure are you?

Correct: B. An embedded CALL option belongs to the ISSUER, not the investor: the issuer can redeem the bond early (typically when rates have fallen, forcing the investor to reinvest at lower rates), so a callable bond is worth LESS to the investor than an equivalent option-free bond, all else equal (Value of callable bond = Value of option-free bond - Value of the call option). A step-up coupon, by contrast, benefits the investor by raising the coupon over time, adding value; combining the two, the call feature reduces value while the step-up feature adds some value back, so the net effect versus a plain fixed-coupon bond depends on the relative size of each, but the call's negative effect on the investor is never simply erased by other features.
A. An embedded call option is a right that benefits the ISSUER, not the bondholder; it does not add value from the investor's perspective, it reduces it, since the issuer will only exercise the call when it is advantageous to the issuer (and therefore disadvantageous to the investor).
C. Embedded options and non-standard coupon structures are explicitly priced DIFFERENTLY from plain, option-free, fixed-coupon bonds; that is the entire reason bond valuation separates out the value of embedded options and special coupon features rather than treating every bond identically.

Unit: fixed-income-instrument-features

Question 10Above the exam

An investor is comparing a plain-vanilla fixed-rate bond to an otherwise identical bond that is puttable by the investor (the investor can force early redemption at par on specified dates). Combining who holds the embedded option with typical interest rate scenarios, the puttable bond is most likely to be exercised by the investor, and is most valuable relative to the plain bond, when:

How sure are you?

Correct: A. A put option embedded in a bond belongs to the INVESTOR: it gives the investor the right to sell the bond back to the issuer at a specified price (typically par), which is most valuable when the bond's market value would otherwise have fallen below that price, exactly the case when interest rates have risen (pushing bond prices down) or the issuer's credit has deteriorated (also pushing the bond's market price down). Because this benefits the investor, a puttable bond is worth MORE than an equivalent option-free bond (Value of puttable bond = Value of option-free bond + Value of the put option).
B. This reverses the logic of who benefits from a put option and when; if rates FALL, bond prices RISE, and the investor would have no reason to put the bond back at par when it is already worth more than par in the market. The put becomes valuable specifically when rates rise (or credit worsens), not when they fall.
C. The put option is regularly exercised in real markets precisely under the rising-rate or deteriorating-credit conditions described, and it is explicitly priced as a real, valuable component added to the option-free bond's value, not treated as worthless.

Unit: fixed-income-instrument-features

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