Estimated study time: 55 minutes
Content:
Debt securities are instruments through which issuers borrow money from investors and promise to repay principal at maturity while making periodic interest payments. They are a cornerstone of the SIE exam's Products and Risks section.
When a corporation, municipality, or government issues a bond, it is selling a debt obligation. The key terms of any bond are: (1) par value (face value, typically $1,000 per bond), the amount returned to the investor at maturity; (2) coupon rate, the annual interest rate expressed as a percentage of par (a 5% coupon on a $1,000 bond pays $50 per year, typically in $25 semiannual installments); and (3) maturity date, when the principal is repaid and the bond ceases to exist.
Bond prices move inversely with interest rates — this is the most tested relationship in all of fixed income. When market interest rates rise, existing bonds with lower coupon rates become less attractive, so their prices fall. When rates fall, existing bonds with higher coupons become more valuable, and their prices rise. This relationship can be remembered with the simple phrase: "rates up, prices down." The sensitivity of a bond's price to interest rate changes is measured by duration — longer-duration bonds experience larger price swings for a given change in rates.
U.S. Treasury securities are issued by the federal government and are considered the safest debt instruments available because they are backed by the "full faith and credit" of the United States — essentially the government's power to tax. Treasury Bills (T-Bills) mature in one year or less and are sold at a discount (paying no coupon); Treasury Notes mature in 2-10 years; Treasury Bonds mature in 10-30 years. TIPS (Treasury Inflation-Protected Securities) adjust their principal value with inflation, protecting investors from purchasing power erosion.
Corporate bonds carry credit risk (also called default risk) — the risk the issuer will fail to make interest or principal payments. Credit ratings from agencies like Moody's (Aaa through C) and S&P (AAA through D) assess this risk. Investment-grade bonds are rated Baa/BBB or higher; speculative-grade (high-yield or "junk") bonds are rated below Baa/BBB. Higher-yield bonds compensate investors for taking on more credit risk.
Municipal bonds are issued by states, cities, counties, and other government entities to fund public projects. The key advantage: interest income on most municipal bonds is exempt from federal income tax and often exempt from state taxes in the issuer's state. This makes munis attractive to high-income investors in high tax brackets. The taxable equivalent yield formula allows comparison with taxable bonds: Taxable Equivalent Yield = Muni Yield / (1 - Tax Bracket).
Callable bonds give the issuer the right to redeem bonds early at a specified price (the call price) after a specified date (the call protection period). Issuers call bonds when interest rates fall so they can refinance at lower rates — exactly when investors would prefer to keep earning the higher coupon. This creates call risk (also called reinvestment risk) for bondholders. Zero-coupon bonds make no periodic interest payments; they are sold at a deep discount and accrete to face value at maturity. The imputed interest is taxable annually even though no cash is received — making them most appropriate for tax-deferred accounts.
Key Terms:
Quiz Questions:
Q1. An investor holds a 4% coupon corporate bond with 20 years to maturity. The Federal Reserve raises interest rates by 2%. What happens to the market price of this bond?
A) The price increases because the bond now pays a higher yield B) The price remains unchanged since the coupon rate is fixed C) The price decreases because newly issued bonds will offer higher yields D) The price increases because longer-term bonds are more valuable
Answer: C — Bond prices move inversely with interest rates. When new bonds are issued at 6%, an existing 4% bond becomes less attractive and must sell at a discount to attract buyers. The longer the maturity, the more the price will fall (greater duration).
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Q2. A municipal bond yields 3.5%. An investor in the 35% federal tax bracket is comparing this to a corporate bond. What taxable equivalent yield must the corporate bond offer to match the muni on an after-tax basis?
A) 3.5% B) 4.5% C) 5.0% D) 5.38%
Answer: D — Taxable Equivalent Yield = 3.5% / (1 - 0.35) = 3.5% / 0.65 = 5.38%. The corporate bond must yield at least 5.38% for a 35% bracket investor to equal the after-tax return of the 3.5% muni.
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