While many, if not most, are introduced to finance through equities, they are actually dwarfed by credit, which is the bulk of the financial market and thus a topic that pretty much everyone working on Wall Street, whether investor, analyst, broker, or something else, will have to be comfortable analyzing.
The starting point is the capital structure, and it is crucial to remember that equity is subordinated to credit and a major reason why debt is attractive to investors: it is less risky than equity, all else considered equally. Additionally, the income production of debt provides an income that compensates for the locked-up capital and risk of losses, and the more stable nature of those payments is a major inducement to invest.
The size of the debt market also means there are additional concepts in debt that equity does not consder. Take, for instance, conversion ratios—these are crucial for convertible bonds and impact not only the bondholders but the entire capital structure. Hence knowing when convertible bondholders are likely to convert is important.
On the Series 7 exam, you’ll likely be asked a question about parity price of a convertible bond or how its conversion ratio means a change in terms for a stock split. For normal bonds that don’t convert, the bond seesaw (discussed in a prior article) and the ability to calculate current yield, yield to maturity, and yield to call need to be in a testtaker’s backpocket.
Beyond the SIE, though, the Series 7 goes deeper and asks about the world around bonds. You’ll need to know what the Bond Buyer is and what information about the primary market it contains and how its indices are made up. You’ll need to know where call provisions are written, when they are disclosed, and how they impact a bond’s risk profile. And on the topic of risk, the many systematic and unsystematic risks of bonds (as well as equities) are all fair game for the test.
Then there are municipal bonds, whose special tax rules are heavily tested (taxes make a bigger appearance on the Series 7 than the SIE, so taxes on gains, income, options, and stocks are all topics test takers will need to prepare). The muni bond issuance process is different, munis are regulated by a different body than other bonds, and the rules on issuance and trading are slightly different as well—those differences are often test topics.
With muni bonds, the difference between General Obligation and revenue bonds is important, and the amortization of premiums (bringing cost basis down) and discounts (bringing cost basis up) is important in addition to how this impacts taxes. For instance, the annual accretion of a discounted bond is classified as ordinary income, so a bond maturing in 3 years at 100 bought at 97 will see one point of accretion per year and the same bond at 103 will see a point of amortization per year, and these are classified as ordinary income for investors.
Fortunately, the steps involved in solving bond questions on the Series 7 are not as in-depth as with options (often seen as the hardest part of the test), so it isn’t important that you practice answering complex math questions as it is important that you practice answering questions about the rules so that you remember the rules. And, in fact, this is arguably true of all of the test, including options—the only problem with options is that, given their complexity, there are a lot of intersecting rules that need to be weighed against each other to determine the correct process for solving the question. For instance, if you have 1 long put and 1 long call, the method of calculating breakeven, max loss and max gain is very different than if you are long 2 calls. Fortunately, no matter the bond the rules you need to figure it out are very simple, and can be mostly summarized by looking at the following:
1. Who is the issuer and what is backing the bond?
2. What is the bid, ask, and current yield?
3. How do those compare to par and nominal yield?
4. What are the call and conversion provisions?
5. How long is the bond’s duration?
While there are other issues, such as the bond’s credit quality, these main questions will get you pretty much all of the relevant data you will need to answer questions on the Series 7 exam—provided you know how to ask the right questions and find the right answers.