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Chapter 8 of 27

Debt Securities I: Bonds, Yields, and Interest Rate Basics

Unpack how bonds work, how yields are quoted, and why interest rate moves can help or hurt different types of fixed-income investors.

27 min readen

Big Picture: Where Bonds Fit in Your SIE Toolkit

From Stocks to Bonds

You learned that common stock is an ownership claim on a corporation. Now we shift to debt securities, where investors are lenders, not owners.

Module Focus

We focus on plain-vanilla bonds: fixed-rate, non-callable, non-convertible. These are the core building blocks for more complex fixed-income products.

What You Will Be Able To Do

You will describe bond structure, compute nominal and current yield, explain price–yield behavior, and identify interest rate, reinvestment, and credit risk.

Why It Matters in 2026

Recent rate hikes caused big bond price moves. Understanding these mechanics explains real-world gains and losses and is central to SIE fixed-income questions.

Bond Structure: Issuer, Par, Coupon, and Maturity

What Is a Bond?

A bond is a loan from investors to an issuer. The issuer promises periodic interest and repayment of principal at maturity.

Issuer Types

Issuers include corporations, the U.S. Treasury, agencies, and municipal securities issuers such as states and cities.

Par (Face) Value

Par value is the principal repaid at maturity, typically $1,000 per bond on SIE-style questions.

Coupon Rate

The coupon rate is the stated annual interest on par. A 5% coupon on $1,000 pays $50 per year, often in two $25 semiannual payments.

Maturity Date

The maturity date is when par is repaid. Longer maturities usually mean greater interest rate risk for the bondholder.

Reading a Bond Description: A Walkthrough

Sample Bond Quote

Example: XYZ Corp 6s of 2034 @ 98. Each part of this quote encodes coupon, maturity, and price information.

Issuer and Coupon

XYZ Corp is the issuer (a corporate bond). 6s means a 6% coupon, or $60 per year on $1,000 par, usually $30 every six months.

Maturity and Price

The bond matures in 2034. @ 98 means it trades at 98% of par, or $980. Below 100 = discount; above 100 = premium.

Quick Intuition Check

You pay $980 and receive $60 per year plus $1,000 at maturity. Since price < par, your current yield is greater than the 6% nominal yield.

Nominal Yield vs Current Yield

Nominal Yield

Nominal yield is the coupon rate printed on the bond. A 4% bond has a 4% nominal yield regardless of its current market price.

Current Yield Formula

Current yield compares annual coupon to current price: `Current yield = Annual coupon interest / Current market price`.

Discount and Premium Patterns

If price < par (discount), CY > nominal. If price > par (premium), CY < nominal. If price = par, CY equals nominal yield.

What CY Ignores

Current yield ignores capital gains/losses at maturity and time value of money. Those are captured by yield to maturity, covered conceptually later.

Practice: Compute and Compare Current Yields

Work through these quick exercises. Try to compute the answer before checking the walkthrough in your head.

  1. ABC 7s of 2030 @ 102
  • Par = $1,000
  • Coupon = 7% → annual interest = 0.07 × 1,000 = $70
  • Price = 102% of par = $1,020
  • Current yield = 70 / 1,020 ≈ 6.86%
  • Compare to nominal yield (7%): CY is slightly lower because the bond trades at a premium.
  1. DEF 3.5s of 2029 @ 95
  • Annual interest = 0.035 × 1,000 = $35
  • Price = 95% of par = $950
  • Current yield = 35 / 950 ≈ 3.68%
  • Compare to nominal yield (3.5%): CY is slightly higher because the bond trades at a discount.
  1. Thought exercise: A bond has a 4% coupon and a current yield of exactly 4%. What must be true about its price relative to par?
  • If nominal = 4% and CY = 4%, the only way this works is if price = par.

Self-check prompts:

  • If the bond is at a premium, do I expect CY to be above or below the coupon?
  • Am I always dividing annual coupon dollars by the current price (not par)?

Take 1–2 minutes to create your own example: pick a coupon, pick a price above or below par, compute the current yield, and decide if it is a discount or premium bond.

Yield to Maturity and the Price–Yield Relationship

What Is YTM?

Yield to maturity (YTM) is the annualized return if you hold the bond to maturity, including coupons and any gain or loss versus par.

Inverse Price–Yield Relationship

When market rates rise, bond prices fall. When market rates fall, bond prices rise. This inverse relationship is core to fixed income.

Why Prices Move

If new bonds offer higher coupons, older low-coupon bonds must trade at lower prices to offer competitive yields, and vice versa.

Yield Ranking: Discount vs Premium

Discount: YTM > CY > nominal. Premium: nominal > CY > YTM for non-callable bonds. This pattern is heavily tested.

Interest Rate Risk and Reinvestment Risk

Interest Rate Risk

Interest rate risk is the risk that changing market rates cause bond prices to move, hurting investors who must sell before maturity.

Who Has More Interest Rate Risk?

Longer-maturity, lower-coupon bonds are more sensitive to rate changes and therefore have greater interest rate risk.

Reinvestment Risk

Reinvestment risk is the risk that future coupon payments must be reinvested at lower rates if market yields decline.

Opposite Directions

Interest rate risk hurts when rates rise (prices fall). Reinvestment risk hurts when rates fall (you reinvest at lower yields).

Credit Ratings, Default Risk, and Yield Spreads

Credit (Default) Risk

Credit risk is the chance the issuer cannot make interest or principal payments, leading to default and potential investor losses.

Credit Ratings

Rating agencies assign investment-grade and speculative-grade ratings to signal relative default risk to investors.

Credit Spreads

A credit spread is the extra yield over a safer benchmark (often Treasuries) that investors demand for taking on more credit risk.

Ratings and Yields

Lower ratings → higher required yields and lower prices. A downgrade usually causes prices to fall and yields to rise.

Quick Check: Yields and Prices

Test your understanding of current yield and price–yield relationships.

A 5% corporate bond with $1,000 par is currently trading at 92. Which statement is MOST accurate?

  1. The bond is trading at a discount and its current yield is greater than 5%.
  2. The bond is trading at a discount and its current yield is less than 5%.
  3. The bond is trading at a premium and its current yield is greater than 5%.
  4. The bond is trading at a premium and its current yield equals 5%.
Show Answer

Answer: A) The bond is trading at a discount and its current yield is greater than 5%.

92 means 92% of par, or $920, so the bond is at a **discount**. Annual interest is 5% × $1,000 = $50. Current yield = 50 / 920 ≈ 5.43%, which is **greater** than the 5% nominal yield. So the bond trades at a discount and its current yield is greater than 5%.

Quick Check: Risks and Ratings

Apply what you know about interest rate risk and credit risk.

Which bond would typically have the GREATEST interest rate risk for an investor?

  1. A 2-year U.S. Treasury note with a 6% coupon
  2. A 30-year corporate bond rated AAA with an 8% coupon
  3. A 30-year corporate bond rated BBB with a 3% coupon
  4. A 5-year municipal bond with a 4% coupon
Show Answer

Answer: C) A 30-year corporate bond rated BBB with a 3% coupon

Interest rate risk is highest for **long-term, low-coupon** bonds. Both choices B and C are 30-year corporates, but C has the **lower coupon (3%)**, making its price more sensitive to rate changes. Credit rating (AAA vs BBB) affects credit risk, not interest rate risk directly, so the 30-year 3% BBB bond has the greatest interest rate risk.

Key Bond Terms: Flashcard Review

Use these flashcards to solidify core terminology before moving on.

Par (face) value
The principal amount a bond issuer agrees to repay at maturity, typically $1,000 per bond on SIE-style questions.
Coupon rate (nominal yield)
The stated annual interest rate on a bond, applied to par value to determine annual coupon dollars; does not change with market price.
Current yield
A bond's annual coupon interest divided by its current market price; measures income return based on today's price and ignores capital gain or loss at maturity.
Yield to maturity (YTM)
The annualized rate of return an investor earns if a bond is held to maturity, including all coupon payments and any gain or loss relative to par.
Interest rate risk
The risk that changes in market interest rates will cause bond prices to fall (when rates rise) or rise (when rates fall), affecting investors who sell before maturity.
Reinvestment risk
The risk that future coupon payments or principal repayments will have to be reinvested at lower interest rates than originally expected.
Credit (default) risk
The risk that a bond issuer will be unable to pay interest or principal as promised, potentially leading to default and investor losses.
Investment-grade bond
A bond rated in the higher quality categories (e.g., S&P BBB- or better, Moody's Baa3 or better), indicating relatively lower default risk.
Speculative-grade (high-yield) bond
A lower-rated bond with higher default risk that must offer higher yields to attract investors; sometimes called a junk bond.
Credit spread
The difference in yield between a riskier bond and a safer benchmark (such as a U.S. Treasury of similar maturity), compensating investors for additional credit risk.

Putting It Together: Investor Scenarios

Apply everything to short scenarios, as the SIE often does.

  1. Retiree seeking stable income
  • Goal: Predictable cash flow, low volatility.
  • Likely preferences:
  • Higher-quality (investment-grade) issuers → lower credit risk.
  • Intermediate maturities (e.g., 5–10 years) → moderate interest rate risk.
  • Be aware of reinvestment risk if rates fall, especially with higher coupons.
  1. Young investor speculating on falling interest rates
  • View: Expects market rates to decline.
  • Likely preferences:
  • Longer-maturity, lower-coupon bonds (or bond funds) → more interest rate sensitivity; bigger price gains if rates fall.
  • Will accept more price volatility in exchange for potential capital gains.
  1. Credit-focused investor seeking higher yield
  • Goal: Maximize income, willing to accept risk.
  • Likely preferences:
  • Speculative-grade corporate bonds with higher coupons.
  • Understands higher credit risk and wider credit spreads vs Treasuries.

Self-test prompts (mentally answer):

  • If rates rise sharply next year, which of the three investors above is hurt the most and why?
  • If a major rating agency downgrades a bond from BBB to BB, what happens to its price and yield in the secondary market?

Spend 2–3 minutes matching each investor type with the main risk they are consciously taking: interest rate risk, credit risk, or reinvestment risk.

Key Terms

bond
A debt security in which an investor lends money to an issuer in exchange for periodic interest payments and repayment of principal at maturity.
par value
The principal amount a bond issuer agrees to repay at maturity, typically $1,000 per bond on SIE-style questions.
coupon rate
The stated annual interest rate on a bond, applied to par value to determine the annual coupon payment.
premium bond
A bond trading above its par value (price > 100% of par).
credit rating
An assessment by a rating agency of an issuer's or bond's creditworthiness, indicating relative default risk.
credit spread
The yield difference between a riskier bond and a safer benchmark, such as a U.S. Treasury of similar maturity.
current yield
A bond's annual coupon interest divided by its current market price; a simple income-based yield measure.
discount bond
A bond trading below its par value (price < 100% of par).
nominal yield
Another term for the coupon rate; the yield based on the bond's stated coupon relative to par value.
secondary market
The market in which previously issued securities are bought and sold among investors, including exchange and over-the-counter trading.
reinvestment risk
The risk that future coupon or principal payments will be reinvested at lower interest rates than initially expected.
interest rate risk
The risk that changes in market interest rates will cause bond prices to move, harming investors who must sell when prices are unfavorable.
municipal securities
Debt securities issued by states, municipalities, or their agencies and authorities, including general obligation and revenue bonds, often offering interest that is exempt from federal income tax.
investment-grade bond
A bond rated in the higher quality categories (e.g., S&P BBB- or better, Moody's Baa3 or better), indicating relatively lower default risk.
speculative-grade bond
A lower-rated, higher-risk bond that must offer higher yields; also called a high-yield or junk bond.
yield to maturity (YTM)
The annualized rate of return an investor earns if a bond is held to maturity, including all coupon payments and any gain or loss relative to par.
credit risk (default risk)
The risk that an issuer will be unable to make scheduled interest or principal payments.

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