Q: Why do bond prices move inversely to interest rates?

A bond's coupons are fixed for its life. When market interest rates rise, newly issued bonds pay higher coupons, so an existing bond with a lower coupon becomes less attractive and its price falls until its YTM matches the new market rate. Duration measures the sensitivity: for every 1% rise in rates, a bond's price falls by approximately its modified duration percentage. A 10-year Treasury with ~9-year duration falls ~9% when rates rise 1%. This is why long-duration bonds sold off ~30% during the Fed's 2022-2023 hiking cycle.

Q: What is a callable bond and how does it affect yield?

A callable bond gives the issuer the right to redeem before maturity, typically after a lockout period (call protection), at par or a small premium. When rates fall, issuers call the bond and refinance at lower rates — capping the investor's upside. For callable bonds, compute Yield to Worst (YTW) = min(YTM, Yield to Call at each call date). Sophisticated investors demand a coupon premium (call risk premium) to compensate. Most corporate and municipal bonds are callable; U.S. Treasuries are generally non-callable except for a small pre-1985 vintage.

Q: How are bond yields taxed in 2026?

U.S. Treasury coupons are subject to federal income tax at ordinary rates (10-37% under IRC §1) but exempt from state and local tax under 31 USC §3124. Municipal bond coupons are exempt from federal tax under IRC §103, and typically from state tax if issued in your state of residence (in-state munis triple-tax-exempt in high-tax states like CA/NY/NJ). Corporate bond coupons are fully taxable federally and at the state level. Original Issue Discount (OID) accrues annually as taxable interest under IRC §1272 even without cash receipt. Capital gain/loss on a bond sold before maturity is taxed at LTCG rates if held >1 year.

Question 1

What is yield to maturity (YTM)?

Accepted Answer

YTM is the internal rate of return of a bond held to maturity, assuming all coupons are reinvested at the YTM itself. It solves the equation: Price = Σ (Coupon / (1+YTM/f)^(f·t)) + Face / (1+YTM/f)^(f·T), where f is coupons per year and T is years to maturity. YTM has no closed-form solution and must be computed iteratively (Newton-Raphson). It is the single most-used yield metric because it accounts for coupon income, capital gain or loss to par at maturity, and time value of money in one figure.

Question 2

How does YTM differ from coupon rate and current yield?

Accepted Answer

Coupon rate = annual coupon ÷ face value (fixed at issuance). Current yield = annual coupon ÷ current market price (updates with price). YTM = internal rate of return to maturity (updates with price, accounts for pull-to-par). For a bond trading at a discount (price < par), YTM > current yield > coupon rate. For a premium bond, YTM < current yield < coupon rate. For a par bond, all three are equal. Current yield ignores the capital gain/loss at maturity; YTM captures it.

Question 3

Why do bond prices move inversely to interest rates?

Accepted Answer

A bond's coupons are fixed for its life. When market interest rates rise, newly issued bonds pay higher coupons, so an existing bond with a lower coupon becomes less attractive and its price falls until its YTM matches the new market rate. Duration measures the sensitivity: for every 1% rise in rates, a bond's price falls by approximately its modified duration percentage. A 10-year Treasury with ~9-year duration falls ~9% when rates rise 1%. This is why long-duration bonds sold off ~30% during the Fed's 2022-2023 hiking cycle.

Question 4

What is a callable bond and how does it affect yield?

Accepted Answer

A callable bond gives the issuer the right to redeem before maturity, typically after a lockout period (call protection), at par or a small premium. When rates fall, issuers call the bond and refinance at lower rates — capping the investor's upside. For callable bonds, compute Yield to Worst (YTW) = min(YTM, Yield to Call at each call date). Sophisticated investors demand a coupon premium (call risk premium) to compensate. Most corporate and municipal bonds are callable; U.S. Treasuries are generally non-callable except for a small pre-1985 vintage.

Question 5

How are bond yields taxed in 2026?

Accepted Answer

U.S. Treasury coupons are subject to federal income tax at ordinary rates (10-37% under IRC §1) but exempt from state and local tax under 31 USC §3124. Municipal bond coupons are exempt from federal tax under IRC §103, and typically from state tax if issued in your state of residence (in-state munis triple-tax-exempt in high-tax states like CA/NY/NJ). Corporate bond coupons are fully taxable federally and at the state level. Original Issue Discount (OID) accrues annually as taxable interest under IRC §1272 even without cash receipt. Capital gain/loss on a bond sold before maturity is taxed at LTCG rates if held >1 year.

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