← SIE Exam: Debt Instruments

SIE Securities Industry Essentials Exam Study Guide

Key concepts, definitions, and exam tips organized by topic.

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SIE Exam: Debt Instruments — Comprehensive Study Guide


Overview


Debt instruments are securities that represent a loan made by an investor to a borrower (corporate, government, or municipal). Bondholders are creditors who receive periodic interest payments and the return of principal at maturity. Understanding bond pricing, yields, types, and risk factors is essential for the SIE exam.


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Bond Fundamentals


Core Structure of a Bond


A bond is a formal promise to repay borrowed money. Every bond has three foundational components:


  • • Par Value (Face Value): The amount repaid at maturity; standard corporate bonds = $1,000
  • • Coupon Rate: The fixed annual interest rate stated on the bond; determines periodic cash payments to the bondholder (Coupon Payment = Coupon Rate × Par Value)
  • • Maturity Date: The date on which the issuer repays the full par value to the bondholder

    • The Inverse Relationship: Prices & Interest Rates


    > 📌 The single most tested concept in debt instruments.


    | When Interest Rates... | Bond Prices... | Why? |

    |---|---|---|

    | Rise | Fall | New bonds offer higher yields; old bonds become less attractive |

    | Fall | Rise | New bonds offer lower yields; old bonds become more attractive |


    Bond Price Terminology


  • • Trading at Par: Market price = $1,000 (coupon rate = prevailing rates)
  • • Trading at a Discount: Market price below $1,000 (prevailing rates > coupon rate)
  • • Trading at a Premium: Market price above $1,000 (prevailing rates < coupon rate)

    • Special Bond Features


    | Bond Type | Key Feature | Who Benefits | Trade-off |

    |---|---|---|---|

    | Callable Bond | Issuer can redeem before maturity | Issuer | Investor bears reinvestment risk; typically higher coupon offered |

    | Putable Bond | Investor can sell back to issuer at par | Investor | Investor accepts lower yield |

    | Convertible Bond | Can be exchanged for issuer's common stock | Investor | Investor accepts lower coupon rate |

    | Zero-Coupon Bond | No periodic interest; issued at deep discount | Varies | No reinvestment income; taxed on phantom interest annually |


    > ⚠️ Watch Out For: Issuers call bonds when interest rates fall (to refinance cheaper). This is bad for investors because they must reinvest proceeds at lower rates — this is called reinvestment risk.


    Key Terms — Bond Fundamentals

  • • Par Value: $1,000 face value of a standard bond
  • • Coupon Rate: Annual interest rate as a percentage of par
  • • Callable Bond: Issuer holds the right to redeem early
  • • Putable Bond: Investor holds the right to sell back early
  • • Convertible Bond: Exchangeable for common stock
  • • Zero-Coupon Bond: No coupon; sold at deep discount; return = difference between purchase price and face value
  • • Bond Indenture: Legal contract outlining all bond terms (covenants, call provisions, collateral, maturity, coupon)

    • ---


    Bond Yields & Pricing


    The Three Key Yield Measures


    | Yield Type | Formula / Definition | Considers |

    |---|---|---|

    | Coupon Rate | Annual interest ÷ Par value | Fixed; set at issuance |

    | Current Yield | Annual interest ÷ Current market price | Market price only |

    | Yield to Maturity (YTM) | Total return if held to maturity | Coupon payments + discount gain OR premium loss |


    Example — Current Yield:

    > Bond: $1,000 par, 5% coupon, trading at $900

    > Current Yield = $50 ÷ $900 = 5.56%


    The Yield Relationships (Premium vs. Discount)


    > 📌 Must memorize these relationships for the exam:


    Discount Bond (Price < $1,000):

    ```

    Coupon Rate < Current Yield < YTM

    ```

    Investor gains the discount at maturity → boosts total return


    Premium Bond (Price > $1,000):

    ```

    Coupon Rate > Current Yield > YTM

    ```

    Investor loses the premium at maturity → reduces total return


    Par Bond (Price = $1,000):

    ```

    Coupon Rate = Current Yield = YTM

    ```


    Yield to Call (YTC)

  • • Used for callable bonds
  • • Calculated assuming the bond is redeemed at the earliest call date, not maturity
  • • Uses the call price (not par) as the ending value

    • Duration

  • • Measures price sensitivity to interest rate changes
  • • Higher duration = greater price volatility
  • • Rule of thumb: A bond with duration of 5 will drop approximately 5% in price for every 1% rise in rates
  • • Longer-maturity and lower-coupon bonds have higher duration

    • Accrued Interest

  • • Interest that has accumulated since the last coupon payment date
  • • In a bond transaction: Buyer pays accrued interest to the seller
  • • Buyer then receives the full coupon on the next payment date (a wash)

    • The Yield Curve


    | Curve Shape | Description | What It Signals |

    |---|---|---|

    | Normal (Positive) | Short-term rates < Long-term rates | Healthy economic growth expected |

    | Inverted | Short-term rates > Long-term rates | Possible recession ahead |

    | Flat | Short and long-term rates roughly equal | Economic uncertainty |


    > ⚠️ Watch Out For: A normal yield curve slopes upward because investors demand higher yields for longer maturities due to inflation risk and uncertainty — not because short-term rates are high.


    Key Terms — Yields & Pricing

  • • Current Yield: Annual interest ÷ current market price
  • • YTM: Total return held to maturity; accounts for premium or discount
  • • YTC: Total return held to earliest call date
  • • Duration: Sensitivity measure of price change relative to interest rate change
  • • Accrued Interest: Earned but unpaid interest; paid by buyer at settlement

    • ---


    Government & Agency Securities


    U.S. Treasury Securities


    | Security | Maturity | Interest Paid | Notes |

    |---|---|---|---|

    | T-Bills | 4, 8, 13, 26, or 52 weeks | Issued at discount; no coupon | Return = face value − purchase price |

    | T-Notes | 2, 3, 5, 7, 10 years | Semiannual coupon | Most common intermediate-term Treasuries |

    | T-Bonds | 30 years | Semiannual coupon | Longest-term Treasury; highest interest rate risk |

    | TIPS | Various | Semiannual coupon; principal adjusts with CPI | Best protection against inflation |


    All Treasury securities are backed by the full faith and credit of the U.S. government.


    TIPS — Treasury Inflation-Protected Securities

  • • Principal adjusts with the Consumer Price Index (CPI)
  • • As inflation rises → principal increases → interest payments increase
  • • At maturity, investor receives the greater of adjusted principal or original par
  • • Interest is subject to federal tax but exempt from state and local tax

    • Agency Securities — Ginnie Mae vs. Fannie Mae/Freddie Mac


    | Agency | Type | Guarantee |

    |---|---|---|

    | Ginnie Mae (GNMA) | Government agency | Direct, explicit U.S. government guarantee |

    | Fannie Mae (FNMA) | Government-Sponsored Enterprise (GSE) | Implied guarantee only (not explicit) |

    | Freddie Mac (FHLMC) | Government-Sponsored Enterprise (GSE) | Implied guarantee only (not explicit) |


    Mortgage-Backed Securities (MBS)

  • • Pool of mortgage loans packaged into a single security
  • • Investors receive pass-through payments of both principal and interest
  • • Key risk: Prepayment risk — when homeowners refinance early (typically when rates fall), investors receive principal back sooner than expected and must reinvest at lower rates

    • > ⚠️ Watch Out For: Ginnie Mae = explicit government guarantee. Fannie Mae & Freddie Mac = implied only. This is a frequently tested distinction.


    Key Terms — Government & Agency Securities

  • • T-Bills: Short-term, zero coupon, sold at discount
  • • T-Notes: 2–10 year maturities, semiannual interest
  • • TIPS: Inflation-protected; principal adjusts with CPI
  • • GNMA: Direct U.S. government guarantee
  • • GSE: Government-Sponsored Enterprise (Fannie/Freddie); implied guarantee
  • • Prepayment Risk: Risk that principal is returned early due to refinancing

    • ---


    Corporate Debt


    Types of Corporate Bonds


    | Type | Backing | Risk Level |

    |---|---|---|

    | Secured Bond | Specific collateral (e.g., mortgage bond, equipment trust) | Lower risk |

    | Debenture | General creditworthiness only; no collateral | Higher risk than secured |

    | High-Yield (Junk) Bond | Below investment-grade credit rating | Highest risk; highest yield |


    Investment Grade vs. High-Yield Ratings


    | Rating Agency | Investment Grade | High-Yield (Junk) |

    |---|---|---|

    | S&P / Fitch | BBB- and above | Below BBB- |

    | Moody's | Baa3 and above | Below Baa3 |


    Commercial Paper

  • • Short-term unsecured corporate debt
  • • Maturities: up to 270 days
  • • Sold at a discount (like T-Bills)
  • • Used for working capital / short-term funding
  • • Exempt from SEC registration (key exam fact!)

    • Corporate Liquidation Priority


    > 📌 Must memorize the order — tested frequently:


    ```

    1. Secured Creditors (e.g., mortgage bondholders)

    2. Unsecured Creditors / Debenture Holders

    3. Preferred Stockholders

    4. Common Stockholders (last in line)

    ```


    > ⚠️ Watch Out For: Common stockholders receive nothing in liquidation until all creditors and preferred stockholders are paid in full. Bondholders always come before stockholders.


    Bond Indenture

    The legal contract between the issuer and bondholders specifying:

  • • Coupon rate and payment schedule
  • • Maturity date
  • • Covenants (restrictions on the issuer)
  • • Call provisions
  • • Collateral pledged (if any)

    • Key Terms — Corporate Debt

  • • Debenture: Unsecured bond; backed by credit only
  • • Commercial Paper: Short-term (<270 days), unsecured, exempt from SEC registration
  • • High-Yield/Junk Bond: Rated below BBB-/Baa3; higher default risk
  • • Bond Indenture: Legal governing document of a bond issue
  • • Secured Bond: Backed by specific collateral

    • ---


    Municipal Bonds


    Two Main Types


    | Type | Backed By | Risk Profile |

    |---|---|---|

    | General Obligation (GO) Bond | Issuer's taxing authority | Generally lower risk |

    | Revenue Bond | Revenue from a specific project (toll road, airport, utility) | Depends on project success |


    > Revenue bonds are not backed by taxing power — if the project fails to generate revenue, bondholders may not be paid.


    Primary Tax Advantage

  • • Interest is exempt from federal income tax
  • • Usually exempt from state and local taxes for residents of the issuing state
  • • Makes munis most attractive to investors in high tax brackets

    • Taxable Equivalent Yield (TEY)


    Formula:

    ```

    TEY = Municipal Bond Yield ÷ (1 − Marginal Tax Rate)

    ```


    Example:

    > Muni yield = 3%, Investor's tax rate = 40%

    > TEY = 3% ÷ (1 − 0.40) = 3% ÷ 0.60 = 5.00%

    > This investor needs a 5% yield on a taxable bond to match the muni's after-tax return.


    Pre-Refunded Municipal Bonds

  • • Issuer sets aside U.S. Treasury securities in escrow to repay bondholders
  • • Effectively makes the bond as safe as a Treasury security
  • • Also called escrowed-to-maturity bonds

    • > ⚠️ Watch Out For: Municipal bond interest is federally tax-exempt, but capital gains on the sale of munis are still taxable. Also, interest on certain "private activity bonds" may be subject to the Alternative Minimum Tax (AMT).


    Key Terms — Municipal Bonds

  • • General Obligation Bond: Backed by taxing power of the issuer
  • • Revenue Bond: Backed solely by project revenues
  • • Taxable Equivalent Yield (TEY): Yield a taxable bond must pay to match a muni's after-tax return
  • • Pre-Refunded Bond: Backed by Treasury escrow; highest safety among munis

    • ---


    Quick Review Checklist


    Use this to confirm your mastery before exam day:


  • • [ ] I know the par value of a standard bond is $1,000
  • • [ ] I can explain the inverse relationship between bond prices and interest rates
  • • [ ] I can identify when a bond trades at a premium vs. discount and why
  • • [ ] I know the yield relationship: Discount → Coupon < CY < YTM | Premium → Coupon > CY > YTM
  • • [ ] I can calculate current yield and taxable equivalent yield (TEY)
  • • [ ] I understand duration as a measure of price sensitivity to interest rate changes
  • • [ ] I know the difference between T-Bills, T-Notes, T-Bonds, and TIPS
  • • [ ] I can distinguish between Ginnie Mae (explicit guarantee) and Fannie/Freddie (implied guarantee)
  • • [ ] I understand prepayment risk in mortgage-backed securities
  • • [ ] I know the corporate liquidation priority: Secured → Unsecured → Preferred → Common
  • • [ ] I can define a debenture and explain why it's riskier than a secured bond
  • • [ ] I know commercial paper maturities (≤270 days) and its SEC registration exemption
  • • [ ] I know the two types of munis: GO bonds (taxing authority) vs. Revenue bonds (project revenue)
  • • [ ] I understand the federal tax exemption for municipal bond interest
  • • [ ] I can identify a callable bond's call risk and who benefits from calling
  • • [ ] I know what a zero-coupon bond is and how investors earn their return
  • • [ ] I understand the shape of a normal yield curve and what it signals

    • ---


    > 💡 Final Tip: On the SIE exam, bond questions often require you to apply the price-yield relationship and identify which type of investor would prefer a particular bond. Always consider tax brackets for munis, reinvestment risk for callables, and credit risk for junk bonds when evaluating answer choices.

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