Debt Securities

Bond Basics

A bond is a debt instrument in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period at a fixed or variable interest rate. Bonds are used by companies, municipalities, states, and governments to finance projects and operations. Understanding bonds is essential for the SIE exam, as debt securities make up a significant portion of the exam content.

Key Bond Terms

Face Value (Par Value): The amount the bondholder receives at maturity. For corporate and government bonds, par value is typically $1,000. Bond prices are quoted as a percentage of par.
Coupon Rate (Nominal Yield): The annual interest rate the issuer pays on the bond's face value. A bond with a 5% coupon rate and $1,000 par value pays $50 per year in interest (usually $25 semi-annually).
Maturity Date: The date on which the bond's principal (face value) is repaid to the bondholder. Maturities can range from a few months to 30+ years.

Current Yield measures the annual return on a bond based on its current market price (not par value). The formula is:

Current Yield = Annual Interest Payment / Current Market Price

Example: A bond with a 6% coupon ($60/year) trading at $900 has a current yield of $60 / $900 = 6.67%. Note that current yield is always higher than the coupon rate when a bond trades at a discount, and lower when it trades at a premium.

Bond Pricing: Premium, Par, and Discount

Bonds do not always trade at their face value. The market price of a bond fluctuates based on changes in prevailing interest rates and the issuer's credit quality:

At Par: The bond trades at 100% of face value ($1,000). This occurs when the coupon rate equals the prevailing market rate.
At a Premium: The bond trades above par (e.g., $1,050). This happens when the coupon rate is higher than prevailing rates. Investors pay more because the bond's interest payments are more attractive than what new bonds offer.
At a Discount: The bond trades below par (e.g., $950). This occurs when the coupon rate is lower than prevailing rates. Investors demand a discount because the bond's interest payments are less attractive.

The SIE exam frequently tests the yield hierarchy for discount and premium bonds:

Discount bond yields (lowest to highest): Coupon (Nominal) Yield < Current Yield < Yield to Maturity (YTM) < Yield to Call (YTC)

Premium bond yields (lowest to highest): YTC < YTM < Current Yield < Coupon Yield

For bonds at par, all yields are equal.

Types of Yields

Nominal Yield (Coupon Rate): The stated interest rate on the bond. It never changes.
Current Yield: Annual interest / Current market price. Changes as the price changes.
Yield to Maturity (YTM): The total return an investor earns if the bond is held to maturity, accounting for the coupon payments, the purchase price, and the gain or loss realized at maturity. This is the most comprehensive yield measure.
Yield to Call (YTC): Similar to YTM, but assumes the bond is called (redeemed early) at the first call date and price. Relevant only for callable bonds.

Corporate Bonds

Corporate bonds are debt securities issued by corporations to raise capital. They offer a wide range of structures, security types, and credit qualities. Corporate bond interest is taxable at both the federal and state level.

Secured vs. Unsecured Bonds

Secured bonds are backed by specific assets or collateral:

Mortgage bonds: Backed by real estate or property. First mortgage bonds have the highest priority claim on the property.
Collateral trust bonds: Backed by securities (stocks and bonds) held in trust as collateral.
Equipment trust certificates: Backed by equipment or other physical assets (commonly used by railroads and airlines).

Unsecured bonds (debentures) are backed only by the issuer's general creditworthiness and ability to pay:

Debentures: Unsecured bonds backed by the full faith and credit of the issuer. Most corporate bonds are debentures.
Subordinated debentures: Rank below regular debentures and secured bonds in liquidation. Higher risk = higher yield.

Special Bond Features

Callable bonds: The issuer can redeem the bond before maturity at a specified call price. Companies call bonds when interest rates fall so they can refinance at lower rates. This is bad for the bondholder who loses their above-market coupon.
Convertible bonds: Can be converted into a fixed number of common shares at the bondholder's option. Convertible bonds offer lower coupon rates because of the conversion feature's value. The conversion price and ratio are set at issuance.
Zero-coupon bonds: Sold at a deep discount to par and make no periodic interest payments. The investor's return is the difference between the purchase price and the face value received at maturity. These bonds are highly sensitive to interest rate changes.

Phantom income on zero-coupon bonds: Even though zero-coupon bonds pay no periodic interest, the IRS requires the holder to report "imputed" or "phantom" interest annually. This means you owe taxes on income you have not actually received. For this reason, zero-coupon bonds are often held in tax-deferred accounts (like IRAs) to avoid this annual tax burden.

Bond Ratings

Credit rating agencies assess the creditworthiness of bond issuers. The three major agencies are Moody's, Standard & Poor's (S&P), and Fitch. Their ratings help investors evaluate default risk:

Investment grade: BBB-/Baa3 and above. These bonds are considered suitable for conservative investors and are eligible for bank and insurance company portfolios.
High yield (junk/speculative): BB+/Ba1 and below. These bonds carry higher default risk and must offer higher yields to attract investors.

The rating scale for S&P/Fitch: AAA, AA, A, BBB (investment grade) | BB, B, CCC, CC, C, D (speculative). Moody's uses: Aaa, Aa, A, Baa | Ba, B, Caa, Ca, C.

U.S. Government Securities

U.S. government securities are considered among the safest investments in the world because they are backed by the full faith and credit of the U.S. government. They are exempt from state and local income taxes (but not federal taxes).

Treasury Securities

Treasury Bills (T-Bills): Short-term securities with maturities of 4, 8, 13, 26, or 52 weeks. T-Bills are sold at a discount to par and do not pay periodic interest. The return is the difference between the purchase price and the par value received at maturity. Minimum investment is $100.
Treasury Notes (T-Notes): Medium-term securities with maturities of 2, 3, 5, 7, or 10 years. They pay semi-annual interest at a fixed coupon rate.
Treasury Bonds (T-Bonds): Long-term securities with 20 or 30-year maturities. They pay semi-annual interest at a fixed coupon rate. T-Bonds have the longest duration and are most sensitive to interest rate changes.
TIPS (Treasury Inflation-Protected Securities): The principal value is adjusted based on the Consumer Price Index (CPI). As inflation rises, the principal increases, and interest payments (calculated on the adjusted principal) also increase. TIPS protect against inflation risk.
STRIPS (Separate Trading of Registered Interest and Principal of Securities): Created when the Treasury or a broker-dealer separates a bond's coupon payments and principal into individual zero-coupon securities. Each component is sold separately at a discount.

Remember Treasury maturity order: "Bills are short, Notes are medium, Bonds are long" or simply "B-N-B" in order of increasing maturity. T-Bills: up to 1 year. T-Notes: 2-10 years. T-Bonds: 20-30 years.

Agency Securities

Government-sponsored enterprises (GSEs) and federal agencies issue securities to support specific sectors of the economy, particularly housing:

GNMA (Ginnie Mae): Government National Mortgage Association. Backed by the full faith and credit of the U.S. government (the only GSE with this guarantee). Issues mortgage-backed securities (MBS).
FNMA (Fannie Mae): Federal National Mortgage Association. NOT backed by the full faith and credit of the government, though there is an implicit guarantee. Purchases mortgages from lenders and packages them into MBS.
FHLMC (Freddie Mac): Federal Home Loan Mortgage Corporation. Similar to Fannie Mae — purchases and securitizes mortgages. Also NOT explicitly backed by the government.

The SIE exam will test whether you know which agency has the full faith and credit backing. Only GNMA (Ginnie Mae) carries the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac do NOT. All three deal with mortgage-backed securities, but only GNMA has the explicit government guarantee.

Municipal Bonds

Municipal bonds ("munis") are debt securities issued by states, cities, counties, and other governmental entities to fund public projects. The primary advantage of municipal bonds is their federal tax exemption: interest earned on most municipal bonds is exempt from federal income tax. If the investor resides in the state of issuance, the interest may also be exempt from state and local taxes ("triple tax-exempt").

General Obligation (GO) Bonds

General obligation bonds are backed by the issuer's full faith, credit, and taxing power. They are not secured by any specific revenue source but by the government's ability to levy taxes. GO bonds are typically issued to fund general public purposes such as schools, roads, and government buildings. They must usually be approved by voter referendum.

The creditworthiness of GO bonds depends on the issuer's tax base, debt levels, demographics, and economic diversity. Analysts look at factors such as per capita income, property tax base, and debt-to-assessed-value ratios.

Revenue Bonds

Revenue bonds are backed by the income generated by a specific project or facility (e.g., toll roads, airports, hospitals, water systems). They are NOT backed by the issuer's taxing power. Revenue bonds generally carry more risk than GO bonds because repayment depends on the project's financial success.

Revenue bonds typically have a flow of funds provision that prioritizes how project revenues are distributed (operating expenses first, then debt service, then reserves, then surplus fund). They also include protective covenants such as rate covenants (requiring the facility to charge rates sufficient to cover debt service).

Tax-Equivalent Yield

Because municipal bond interest is tax-exempt, investors need to compare muni yields to taxable yields on an apples-to-apples basis. The tax-equivalent yield formula converts a tax-free yield to its equivalent taxable yield:

Tax-Equivalent Yield = Tax-Free Yield / (1 - Tax Rate)

An investor in the 32% federal tax bracket is considering a municipal bond yielding 4%. What taxable yield would be equivalent?

Tax-Equivalent Yield = 4% / (1 - 0.32) = 4% / 0.68 = 5.88%

The investor would need a taxable bond yielding at least 5.88% to match the after-tax return of the 4% tax-free municipal bond. The higher the investor's tax bracket, the more attractive municipal bonds become.

Tax-Equivalent Yield Calculator

Calculate what taxable yield you would need to match a tax-exempt municipal bond yield.

Tax-Free Yield (%)

Federal Tax Rate (%)

Tax-Equivalent Yield —

Feature	Corporate Bonds	U.S. Government	Municipal Bonds
Federal Tax	Taxable	Taxable	Exempt
State/Local Tax	Taxable	Exempt	Often exempt (if in-state)
Credit Risk	Varies (investment grade to junk)	Lowest (full faith & credit)	Low to moderate
Backing	Corporate assets/creditworthiness	U.S. government	Taxing power (GO) or revenues
Typical Yield	Highest (to compensate for risk/taxes)	Moderate	Lowest nominal (tax advantage makes up for it)
Regulatory Oversight	SEC / FINRA	Treasury Department / Fed	MSRB / FINRA (enforcement)

The Yield Curve and Interest Rate Risk

The yield curve is a graphical representation of yields on bonds of the same credit quality across different maturities. It is one of the most important tools for understanding the bond market and the economy. The yield curve for U.S. Treasuries is the most commonly referenced benchmark.

Figure 3.1 — The three shapes of the yield curve. A normal curve slopes upward (longer maturities = higher yields). An inverted curve slopes downward (often signals recession). A flat curve indicates economic uncertainty.

Yield Curve Shapes

Normal (Positive) Yield Curve: The most common shape. Longer-term bonds have higher yields than shorter-term bonds. This makes sense because investors demand higher compensation for the additional risk of holding bonds for longer periods (more exposure to inflation, interest rate changes, and default). A normal curve generally signals economic growth.
Inverted (Negative) Yield Curve: Short-term yields exceed long-term yields. This unusual situation often signals that investors expect an economic slowdown or recession. An inverted yield curve has historically been one of the most reliable recession predictors.
Flat Yield Curve: Short-term and long-term yields are approximately equal. A flat curve typically appears during transitions between normal and inverted curves, signaling economic uncertainty.

The Price/Yield Seesaw

Figure 3.2 — The Price/Yield Seesaw. Bond prices and yields always move in opposite directions. When interest rates rise, bond prices fall, and vice versa.

Bond Risks

Bond investors face several types of risk:

Interest Rate Risk: The risk that rising interest rates will cause bond prices to fall. Longer-term bonds and lower coupon bonds are more sensitive to interest rate changes. This is the primary risk for most bond investors.
Reinvestment Risk: The risk that coupon payments or principal received at maturity will be reinvested at lower rates. This is the opposite of interest rate risk. Zero-coupon bonds have no reinvestment risk because they make no periodic payments.
Credit (Default) Risk: The risk that the issuer will fail to make interest or principal payments. U.S. Treasuries have virtually no credit risk. Corporate junk bonds have high credit risk.
Call Risk: The risk that a callable bond will be redeemed early when interest rates fall, forcing the investor to reinvest at lower rates. Call risk is a form of reinvestment risk.
Inflation (Purchasing Power) Risk: The risk that inflation will erode the real value of fixed interest payments. Fixed-rate bonds are most vulnerable. TIPS protect against inflation risk.
Liquidity Risk: The risk of not being able to sell a bond quickly at a fair price. Treasury securities have excellent liquidity; some municipal or corporate bonds may be thinly traded.

Interest rate risk and reinvestment risk are inversely related. When interest rates rise, bond prices fall (bad for sellers), but reinvestment rates improve (good for reinvesting coupon income). When rates fall, bond prices rise (good for sellers), but reinvestment rates worsen. Zero-coupon bonds eliminate reinvestment risk entirely but have the highest interest rate risk among bonds of the same maturity.

Deep Dive Understanding Duration and Bond Price Sensitivity

Duration is a measure of a bond's price sensitivity to changes in interest rates. It is expressed in years and represents the weighted average time until a bond's cash flows are received. The higher the duration, the more sensitive the bond is to interest rate changes.

Key duration principles:

Longer maturity = higher duration = greater price sensitivity
Lower coupon rate = higher duration (fewer interim cash flows shift the weighted average further out)
A zero-coupon bond's duration equals its maturity (since all cash flow comes at the end)
Higher yields = slightly lower duration (cash flows are discounted more heavily, giving less weight to distant payments)

Modified duration estimates the percentage change in a bond's price for a 1% change in yield. For example, a bond with a modified duration of 7 would be expected to lose approximately 7% of its value if interest rates rise by 1%, or gain 7% if rates fall by 1%.

Practical application: If you expect interest rates to rise, you would want to shorten your portfolio's duration (shorter maturities, higher coupons) to reduce price losses. If you expect rates to fall, you would lengthen duration to maximize price gains. This is the foundation of active bond portfolio management.

Convexity: Duration provides a linear approximation of price changes, but the actual relationship between prices and yields is curved (convex). Convexity measures the curvature. Bonds with higher convexity will gain more when rates fall and lose less when rates rise than duration alone would predict. Higher convexity is always desirable for a bondholder.