Overview
Debt securities represent loans made by investors to issuers (corporations, governments, municipalities) in exchange for periodic interest payments and the return of principal at maturity. Understanding bond fundamentals, pricing, yield calculations, and risk factors is essential for the SIE exam. This guide covers all major debt security categories tested on the exam, from T-Bills to municipal bonds to credit ratings.
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Bond Fundamentals
Core Concepts
A bond is a debt instrument where the issuer (borrower) promises to pay the bondholder (lender) periodic interest and repay the principal at a specified future date.
Key Terms
• Par Value (Face Value): The standard amount a bond repays at maturity — typically $1,000 for corporate bonds
• Coupon Rate: The annual interest rate paid as a percentage of par value (e.g., 6% coupon on $1,000 = $60/year)
• Bond Indenture: The legal contract between issuer and bondholders specifying coupon rate, maturity, covenants, and other terms
• Callable Bond: Gives the issuer the right to redeem the bond before maturity at a set call price
• Putable Bond: Gives the holder the right to sell the bond back to the issuer before maturity
• Zero-Coupon Bond: Issued at a deep discount; pays no periodic interest; investor's return = difference between purchase price and par at maturity
The Most Important Relationship in Bond Markets
> Bond prices and interest rates move INVERSELY.
> - Rates ↑ → Bond prices ↓
> - Rates ↓ → Bond prices ↑
Premium vs. Discount
| Situation | Bond Price | Why |
|---|---|---|
| Trading at a Premium | Above par ($1,000) | Coupon rate > Current market rates |
| Trading at Par | Equal to par ($1,000) | Coupon rate = Current market rates |
| Trading at a Discount | Below par ($1,000) | Coupon rate < Current market rates |
⚠️ Watch Out For
• Don't confuse callable vs. putable bonds — callable benefits the issuer; putable benefits the investor
• A bond trading at a premium does NOT mean it's a bad investment — it simply reflects current rate conditions
• Zero-coupon bonds have no reinvestment of coupon income risk, but they are highly sensitive to rate changes
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Yield & Pricing
Yield Calculations
Current Yield:
```
Current Yield = Annual Coupon Payment ÷ Current Market Price
Example: $60 ÷ $900 = 6.67%
```
Yield to Maturity (YTM):
• The most comprehensive yield measure
• Accounts for coupon payments, price appreciation/depreciation, and time to maturity
• Assumes bond is held to maturity and coupons are reinvested
Yield to Call (YTC):
• Measures total return assuming the bond is called at the earliest call date
• Used for callable bonds when rates have fallen and calling is likely
The Yield Hierarchy (Must Memorize)
For a bond trading at a DISCOUNT:
> Coupon Yield < Current Yield < Yield to Maturity
> (The investor gains extra return from price appreciation toward par)
For a bond trading at a PREMIUM:
> Coupon Yield > Current Yield > Yield to Maturity
> (The investor loses return from price declining toward par)
For a bond trading at PAR:
> Coupon Yield = Current Yield = Yield to Maturity
Other Key Pricing Concepts
• Accrued Interest: Interest earned by the seller since the last coupon date; the buyer pays the clean price plus accrued interest at settlement
• Basis Point: Equal to 1/100th of 1% (0.01%); used to express small yield/rate changes (e.g., a rate move from 5.00% to 5.25% = 25 basis points)
⚠️ Watch Out For
• YTM is not the same as current yield — YTM is always the better indicator of total return
• Accrued interest goes to the seller, not the buyer, even though the buyer pays it at settlement
• A bond priced at $950 is at a discount (below $1,000 par); never confuse the dollar price with the yield
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Corporate & Government Bonds
Corporate Bond Types
| Bond Type | Backing | Risk Level |
|---|---|---|
| Secured Bond | Specific collateral (e.g., real estate, equipment) | Lower |
| Debenture | General creditworthiness only; no collateral | Higher |
| Convertible Bond | Can be converted into issuer's common stock | Hybrid |
Liquidation Priority Order (Must Memorize)
1. Secured Bondholders (highest priority)
2. Unsecured Bondholders (Debentures)
3. Preferred Stockholders
4. Common Stockholders (lowest priority — last to be paid)
U.S. Government Securities
| Security | Maturity | Interest |
|---|---|---|
| Treasury Bills (T-Bills) | Up to 52 weeks | Sold at discount; no coupon |
| Treasury Notes | 2–10 years | Semi-annual coupon |
| Treasury Bonds | 10–30 years | Semi-annual coupon |
| TIPS | Various | Principal adjusts with CPI inflation |
TIPS Detail: Because the principal adjusts upward with inflation, the coupon payment (a fixed % of principal) also increases — providing a real hedge against inflation.
Agency Securities: A Critical Distinction
| Issuer | Type | Government Guarantee |
|---|---|---|
| Ginnie Mae (GNMA) | Government agency | Full faith and credit of U.S. government ✅ |
| Fannie Mae (FNMA) | GSE | Implied guarantee only ⚠️ |
| Freddie Mac (FHLMC) | GSE | Implied guarantee only ⚠️ |
⚠️ Watch Out For
• T-Bills pay no coupon — return comes entirely from the discount at purchase
• Only Ginnie Mae has the direct U.S. government backing — Fannie Mae and Freddie Mac are GSEs with implied (not explicit) backing
• Convertible bonds typically carry lower coupon rates because the conversion feature has value to the investor
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Municipal Securities
The Two Main Types
| Type | Backed By | Safety |
|---|---|---|
| General Obligation (GO) Bonds | Issuer's full taxing power | Generally safer |
| Revenue Bonds | Income from a specific project (toll roads, airports, utilities) | Dependent on project success |
Tax Advantage of Municipal Bonds
• Interest is exempt from federal income tax
• May also be exempt from state and local taxes if the investor lives in the issuing state
• This makes munis especially attractive to high-income investors in high tax brackets
Taxable Equivalent Yield Formula (Key Calculation)
```
Taxable Equivalent Yield = Municipal Yield ÷ (1 – Investor's Tax Rate)
Example: 4% muni yield, 30% tax bracket
TEY = 4% ÷ (1 – 0.30) = 4% ÷ 0.70 = 5.71%
(A taxable bond must yield 5.71% to match this muni's after-tax return)
```
Short-Term Municipal Instruments
• Bond Anticipation Note (BAN): Short-term borrowing in anticipation of a future long-term bond issue; repaid with proceeds from the bond sale
• Other notes include Tax Anticipation Notes (TANs) and Revenue Anticipation Notes (RANs)
⚠️ Watch Out For
• GO bonds are NOT always better than revenue bonds in practice — a strong revenue-generating project may outperform a financially stressed municipality
• Muni bond interest is not automatically exempt from all taxes — state/local exemption depends on the investor's state of residence
• The taxable equivalent yield formula shows why high-bracket investors favor munis — always calculate TEY to compare fairly
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Risk & Credit Quality
Credit Ratings
| Rating (S&P/Fitch) | Rating (Moody's) | Category |
|---|---|---|
| AAA to BBB- | Aaa to Baa3 | Investment Grade |
| BB+ and below | Ba1 and below | Speculative / High-Yield ("Junk") |
• Investment grade = BBB-/Baa3 or higher → lower risk, lower yield
• Below investment grade = higher yield to compensate for greater default risk
Key Risk Types
| Risk | Definition |
|---|---|
| Default Risk | Issuer fails to make interest or principal payments |
| Credit Risk | Broader risk of value decline due to deteriorating creditworthiness (including downgrades before actual default) |
| Interest Rate Risk | Bond prices fall when market interest rates rise |
| Reinvestment Risk | Coupon payments reinvested at lower rates than original yield |
| Call Risk | Issuer calls bond when rates drop, forcing reinvestment at lower rates |
Duration — A Key Concept
• Duration measures a bond's price sensitivity to interest rate changes
• Higher duration = greater price volatility
• Rule of thumb: For every 1% change in interest rates, bond price changes approximately by its duration percentage
• Long-maturity, low-coupon bonds have the highest duration (most sensitive)
• Short-maturity, high-coupon bonds have lower duration (less sensitive)
Call Risk vs. Reinvestment Risk Connection
> Call risk and reinvestment risk are closely linked — when a bond is called (call risk), the investor must reinvest at lower rates (reinvestment risk). Both typically occur in declining rate environments.
⚠️ Watch Out For
• Default risk and credit risk are NOT the same — credit risk includes downgrades even without default
• Zero-coupon bonds have no reinvestment risk on coupon payments (there are none), but they have the highest duration and interest rate sensitivity
• Higher yield ALWAYS signals higher perceived risk — there is no free lunch in bond markets
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Quick Review Checklist
Bond Fundamentals
• [ ] Standard corporate bond par value = $1,000
• [ ] Bond prices and interest rates move inversely
• [ ] Callable = issuer's right; Putable = holder's right
• [ ] Bond indenture is the legal contract governing bond terms
Yield & Pricing
• [ ] Current Yield = Annual coupon ÷ Market price
• [ ] YTM is the most comprehensive yield measure
• [ ] Discount bond: Coupon < Current Yield < YTM
• [ ] Premium bond: Coupon > Current Yield > YTM
• [ ] 1 basis point = 0.01%
Corporate & Government Bonds
• [ ] Debentures = unsecured corporate bonds
• [ ] Liquidation order: Secured → Unsecured → Preferred → Common
• [ ] T-Bills = discount instrument, no coupon, up to 52 weeks
• [ ] Notes = 2–10 years; Bonds = 10–30 years (both pay semi-annual coupons)
• [ ] TIPS principal adjusts with CPI inflation
• [ ] Only Ginnie Mae = full U.S. government guarantee
Municipal Securities
• [ ] GO bonds backed by taxing power; Revenue bonds backed by project income
• [ ] Muni interest = federally tax-exempt
• [ ] TEY = Muni yield ÷ (1 – tax rate)
• [ ] BAN = short-term note issued in anticipation of bond proceeds
Risk & Credit Quality
• [ ] Investment grade = BBB-/Baa3 or higher
• [ ] Below BBB- = speculative/junk bonds
• [ ] Duration = measure of interest rate price sensitivity
• [ ] Call risk and reinvestment risk both peak in falling rate environments
• [ ] Default risk ≠ credit risk (credit risk is broader)
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Focus your exam preparation on the yield hierarchy for discount/premium bonds, the liquidation priority order, the Ginnie Mae vs. GSE distinction, and the taxable equivalent yield formula — these are high-frequency SIE exam topics.