Debt Securities

Section: Understanding Products and Their Risks — Debt Securities

Estimated study time: 50 minutes

Content:

A debt security (bond) is a loan from the investor to the issuer. The issuer promises to pay periodic interest and to return the principal (par value, conventionally $1,000 for a corporate bond) at maturity. The bondholder is a creditor, not an owner, and therefore has priority over stockholders in a liquidation. The core relationship every candidate must internalize is the inverse relationship between bond prices and interest rates: when market interest rates rise, existing bond prices fall, and when rates fall, existing bond prices rise. This happens because a bond's fixed coupon becomes relatively less attractive when newly issued bonds pay more, so its price must drop until its yield matches the market.

Yield has several meanings, and the SIE tests the ranking among them. The nominal (coupon) yield is the fixed stated rate on the bond. The current yield equals the annual coupon divided by the current market price. Yield to maturity (YTM) is the total annualized return if the bond is held to maturity, accounting for the coupon plus any gain or loss between the purchase price and par. When a bond trades at a discount (below par), the yields rank from lowest to highest as: nominal, current, YTM. When a bond trades at a premium (above par), the order reverses: nominal, current, YTM ranked from highest to lowest. A bond trading exactly at par has all three yields equal to the coupon rate. Callable bonds add yield to call (YTC); for a premium bond, the exam expects you to quote the lower of YTM and YTC (yield to worst).

Bonds…