SIE Debt Securities: Bonds, Yields, and Interest Rate Risk Explained

Debt securities questions are some of the most calculation-intensive content on the SIE exam. Candidates who do not understand the mechanics of bond pricing and yield calculations — not just the vocabulary — lose points on questions that are otherwise straightforward. This guide covers the tested concepts in the order of difficulty you will encounter them.

Bond Pricing: Premium, Par, and Discount

A bond is issued with a par value (also called face value) of $1,000. The coupon rate is the stated annual interest rate, expressed as a percentage of par. A bond with a 5% coupon pays $50 per year in interest regardless of what happens to market prices.

When market interest rates rise above the coupon rate, the bond becomes less attractive than newly issued bonds, so its price falls below par — it trades at a discount. When market rates fall below the coupon rate, the bond pays more interest than new issues, so its price rises above par — it trades at a premium.

This is the central price-yield relationship: bond prices and yields move inversely. This relationship is tested directly and indirectly throughout the SIE. When you see a question about what happens to existing bond prices when the Federal Reserve raises rates, the answer is that prices fall.

Yield Measures

Three yield measures appear on the SIE, and knowing which is highest or lowest under given conditions is frequently tested.

Coupon Rate is the fixed annual interest payment divided by par value. It does not change after issuance.

Current Yield = Annual Interest Payment / Current Market Price

Current yield reflects what the investor actually earns relative to what they paid. For a discount bond, current yield is higher than the coupon rate (you paid less for the same fixed payment). For a premium bond, current yield is lower than the coupon rate.

Yield to Maturity (YTM) accounts for the coupon payments, the time value of money, and the gain or loss the investor experiences if they hold the bond to maturity. For a discount bond, the investor will receive par at maturity — more than they paid — so YTM is higher than current yield. For a premium bond, the investor receives less than they paid, so YTM is lower than current yield.

The relationship to remember:

• Discount bond: Coupon Rate < Current Yield < YTM
• Premium bond: Coupon Rate > Current Yield > YTM
• Par bond: Coupon Rate = Current Yield = YTM

Duration and Interest Rate Risk

Duration measures a bond's price sensitivity to interest rate changes. The higher the duration, the more the bond's price will change for a given change in interest rates. Duration increases with maturity (longer-maturity bonds are more sensitive to rate changes) and decreases with higher coupon rates (because higher coupons return more cash flow sooner, reducing the effective payback period).

The SIE does not require duration calculations, but you should understand the directional relationships:

• Longer maturity → higher duration → more interest rate risk
• Higher coupon rate → lower duration → less interest rate risk
• Zero-coupon bonds have the highest duration of all bonds with the same maturity

Credit Quality and Ratings

Credit rating agencies (Moody's, S&P, Fitch) assess the probability that a bond issuer will meet its debt obligations. The rating scale breaks into two broad categories:

Investment Grade: Moody's Aaa through Baa3 / S&P AAA through BBB−

Speculative Grade (High-Yield/Junk): Moody's Ba1 and below / S&P BB+ and below

Investment-grade bonds carry lower yields because investors accept lower compensation for lower default risk. High-yield bonds must offer higher yields to attract investors willing to accept greater credit risk. Institutional investors such as pension funds and insurance companies are often restricted by policy or regulation to investment-grade holdings.

Callable Bonds and Yield to Call

A callable bond allows the issuer to redeem the bond before maturity at a specified call price (usually at a premium to par). Issuers call bonds when interest rates fall — they retire high-coupon debt and reissue at lower rates.

Yield to Call (YTC) is calculated the same way as YTM, but the call date and call price replace the maturity date and par value. Because callable bonds can be redeemed early, investors demand a higher yield to compensate for call risk (the risk of receiving principal back when rates are low and reinvestment opportunities are limited).

For bonds trading at a premium, YTC is typically lower than YTM — the investor's return is reduced if the issuer calls the bond and the investor must reinvest at lower rates.

Government, Corporate, and Municipal Bonds

U.S. Treasury securities are backed by the full faith and credit of the federal government. They carry no credit risk and are exempt from state and local income tax (but not federal). Treasury bills mature in one year or less, Treasury notes mature in 2–10 years, and Treasury bonds mature in 20–30 years.

Corporate bonds carry credit risk and are fully taxable at federal, state, and local levels. They offer higher yields than Treasuries of comparable maturity to compensate for the additional risk.

Municipal bonds are issued by state and local governments. Interest is generally exempt from federal income tax and may be exempt from state and local tax in the issuing state. The tax advantage means munis carry lower pre-tax yields than comparable taxable bonds. The taxable equivalent yield (TEY) = Tax-Exempt Yield / (1 − Marginal Tax Rate).

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Test your debt securities knowledge with SIE practice questions at advisorexams.com/exams/sie.