Debt instruments are financial contracts where borrowers agree to repay lenders over time, often with interest. They include bonds, loans, and debentures issued by governments, corporations, and financial institutions.
This page of our free SIE study guides covers everything about debt instruments. You’ll learn about debt instruments issued by governments, corporations, and agencies.
Debt issuers acquire funds from investors, pay interest for the capital’s use, and eventually repay the principal amount at maturity. This cycle enables governments, corporations, and financial institutions to finance operations while providing returns to investors.
Treasury Securities
Treasury Securities are debt instruments issued by the U.S. Department of the Treasury to finance government expenditures. They include Treasury bills, notes, and bonds, considered low-risk investments.
- Treasury Bills (T-Bills): These are short-term debt securities issued by the U.S. government, typically with a one-year or less maturity period. They are sold at a discount to their face value and mature at par. T-Bills are considered low-risk investments and are famous for their liquidity and stability.
- Treasury Notes: These are medium-term debt securities issued by the U.S. Department of the Treasury, with two to ten years of maturity. They pay a fixed interest rate every six months and are sold in denominations of $100. Treasury Notes are valued for safety and are actively traded in the secondary market.
- Treasury Bonds: These are long-term debt securities issued by the U.S. Department of the Treasury, with over ten years of maturity. They pay a fixed interest rate semiannually and are sold in denominations of $100. Treasury Bonds are prized for their stability and are sought after by investors seeking long-term income and capital preservation.
Bill Auctions: It is the primary method through which Treasury bills (T-bills) are issued by the U.S. Department of the Treasury. In these auctions, investors bid on T-bills, specifying the quantity they want to purchase and the price they are willing to pay. The Treasury accepts bids starting from the highest price (lowest yield) and continues until the total amount offered is filled. Successful bidders purchase T-bills at their bid price, and unsuccessful bids are rejected.
Ginnie Mae/Fannie Mae/Freddie Mac: Ginnie Mae, Fannie Mae, and Freddie Mac are government-sponsored enterprises (GSEs) in the housing finance market. Ginnie Mae guarantees mortgage-backed securities (MBS) backed by government-insured loans, while Fannie Mae and Freddie Mac purchase mortgages from lenders, bundling them into MBS for investors.
Municipal Securities
Municipal Securities are issued by the state and local governments to finance public projects such as schools, highways, and utilities. These securities include municipal bonds, notes, and other debt obligations. Understanding Municipal Securities is essential for the SIE exam as they play a vital role in the fixed-income market, offering tax-exempt investment opportunities to investors.
- General Obligation Bonds: These municipal bonds are backed by the issuing government’s full faith, credit, and taxing authority. They finance public projects like infrastructure and education. General Obligation bonds are deemed low-risk due to the issuer’s ability to use taxes for repayment.
- Revenue Bonds: These municipal bonds are issued to finance specific projects, such as toll roads, airports, or utilities. Unlike General Obligation Bonds, they are backed by the revenue generated by the project they finance rather than the issuer’s taxing power.
- Special Tax Bonds: These municipal bonds are issued to finance specific projects or initiatives backed by designated taxes or assessments rather than the general taxing authority of the issuer. These bonds are secured by revenues from the special taxes levied on properties or transactions related to the funded project.
- Authority Bonds: These municipal bonds are issued by quasi-governmental entities or special-purpose agencies, such as transportation authorities or housing agencies. These bonds are typically backed by the revenue generated from the projects or services provided by the issuing authority rather than the general taxing power of the government.
- Taxable Bonds: These are debt securities on which interest income is subject to federal income tax. They are issued by corporations, foreign governments, or municipalities for projects that do not qualify for tax-exempt status.
- Municipal Notes: These are short-term debt securities issued by state and local governments to finance immediate funding needs, such as cash flow shortages or capital projects. They typically mature in one year or less and are commonly used to bridge funding gaps until longer-term financing can be arranged.
Corporate Bonds
Corporate Bonds are debt securities issued by corporations to raise capital for various purposes, such as expansion, acquisitions, or debt refinancing. They typically offer fixed interest (coupon payments) and return the principal investment at maturity.
- Zero-Coupon Bonds: These are debt securities that do not pay periodic interest but are sold at a discount to their face value. They are redeemed at face value upon maturity, providing investors with a return on investment through capital appreciation.
- Convertible Bonds: These are corporate bonds that allow bondholders to convert their bonds into a specified number of common stock shares of the issuing company. This feature enables investors to participate in potential stock price appreciation while enjoying the benefits of fixed-income payments.
Money Market Instruments
Money Market Instruments are short-term debt securities with high liquidity and low risk, typically for one year or less. These instruments include Treasury bills, commercial paper, and certificates of deposit (CDs).
Certificates of Deposit (CD): These are fixed-term deposit accounts offered by banks and credit unions. Investors deposit funds for a specified period, earning interest at a predetermined rate. CDs offer higher interest rates than regular savings accounts but require funds to be locked in until maturity, typically ranging from a few months to several years.
Banker’s Acceptances: These are short-term debt instruments issued by a bank on behalf of a customer. They represent a promise by the bank to pay a specified amount to the holder on a future date, typically used in international trade transactions. Banker’s Acceptances provide a secure means of financing and are often traded in the secondary market.
Commercial Papers: These are short-term debt securities issued by corporations to raise funds for immediate financing needs. They typically have a maturity period ranging from a few days to a year and are usually sold at a discount to their face value. Commercial Papers offer corporations a flexible and cost-effective way to meet short-term funding requirements.
Par Value
Par Value is the nominal value assigned to a security at issuance. It represents the security’s face value or principal amount and is used to calculate interest payments and determine redemption value at maturity.
Interest Rate
The Interest Rate is the percentage of principal a lender charges for the use of borrowed money, typically expressed as an annual percentage. It determines the amount of interest paid or earned on a loan or investment and is a crucial factor in financial decision-making.
Length to Maturity
Length to Maturity refers to the time remaining until a bond or other fixed-income security reaches its maturity date. It determines the duration of the investment and influences its risk and return characteristics. Bonds with longer maturities typically offer higher yields but are subject to greater interest rate risk.
Accrued Interest
Accrued Interest is the interest earned or payable on a bond or other fixed-income security since the last interest payment date. It accumulates daily based on the bond’s coupon rate and the days since the last payment. Accrued Interest is vital for bond transactions, as buyers compensate sellers for accrued interest up to the settlement date.
Yields
In the securities industry, “yield” signifies the rate of return on an investment. For stocks, it’s often gauged by dividends, while for bonds, it’s assessed by interest. Various formulas exist for measuring bond yield, including yield to maturity (YTM) and current yield.
- Current Yield: Current Yield represents the annual income generated by a bond relative to its current market price. It is calculated by dividing the bond’s annual interest payment by its current market price and is expressed as a percentage. Current Yield provides investors with insights into the income potential of a bond investment based on its current market value.
- Yield to Maturity (YTM): Yield to Maturity (YTM) is the total return anticipated from a bond if held until maturity, accounting for its current market price, coupon payments, and principal repayment. YTM considers both interest income and capital gains or losses and is a crucial metric for bond valuation and investment analysis.
- Yield to Call (YTC): Yield to Call (YTC) is the anticipated return on a bond if it is called by the issuer before its maturity date. It factors in the bond’s current market price, the call price, and the time remaining until the call date. YTC helps investors assess the potential return on callable bonds and make informed investment decisions.
Other Bond Features
Issuers often include additional provisions in bond offerings to appeal to investors. While these features are optional, they can enhance the attractiveness of the bonds. Understanding these provisions is crucial for investors evaluating bond investments.
- Callable: Callable bonds give issuers the right to redeem the bonds before maturity. This feature allows issuers to refinance debt or respond to financial changes. Callable bonds may offer higher yields but involve the risk of early redemption.
- Puttable: Puttable bonds grant investors the right to sell back bonds to the issuer before maturity at a predetermined price. This feature allows investors to exit investments early, potentially mitigating downside risk.
- Zero-Coupon: Zero-Coupon bonds are debt securities that do not pay periodic interest. They are sold at a discount to their face value and redeemed at total value upon maturity. Zero-coupon bonds offer capital appreciation and are famous for long-term investing.
- Convertible: Convertible bonds allow bondholders to convert bonds into a specified number of common stock shares of the issuing company. This feature offers the potential for stock price appreciation while retaining fixed-income benefits.
Insured (Municipals Only): Insured municipal bonds have insurance coverage guaranteeing repayment of principal and interest by a third-party insurer in case of issuer default. This feature enhances bond credit quality and may lower borrowing costs.
Bond Rating Agencies
Bond rating agencies, such as Moody’s, Standard & Poor’s (S&P), and Fitch Group, evaluate the credit risk of debt securities and their issuers. They assign ratings ranging from AAA (highest quality, lowest risk) to lower ratings like Bs and Cs (indicating higher risk). These ratings are crucial for investors assessing bond investments.
Priority in Liquidation
In the event of liquidation, bondholders are prioritized based on their bond’s seniority. Senior secured debt holds the highest priority, followed by senior debt and subordinated debt. Senior debt is often secured by assets, while subordinated debt is unsecured. Debt takes precedence over equity in the payment hierarchy.
Relationship between Price and Interest Rate
The relationship between bond prices and interest rates is inverse: as interest rates rise, bond prices fall, and vice versa. This occurs because existing bonds with lower interest rates become less attractive, causing their prices to decrease to match higher-yielding alternatives.
- Impact of length to maturity: Length to maturity affects the sensitivity of bond prices to changes in interest rates. Longer maturities result in higher price volatility, as these bonds have more future cash flows exposed to interest rate fluctuations.
- Impact of credit rating (AAA, AA, etc.): Higher credit ratings, such as AAA or AA, indicate lower credit risk, making bonds more desirable. As a result, bonds with higher ratings typically have lower yields and higher prices than lower-rated bonds.
Risks of Debt Securities
Generally, investments in bond securities are considered safe, but they can still be exposed to various risks, including credit risk, interest rate risk, liquidity risk, inflation risk, etc.
- Interest Rate Risk: It refers to the potential decline in bond value resulting from unexpected changes in interest rates. Bond prices typically fall when rates rise, and vice versa, impacting bondholders’ investment returns.
- Inflation Risk: It refers to the risk of high inflation when the purchasing power of money decreases. In this case, the expected rate of return on bond investment decreases.
- Credit Risk: It refers to the potential that the issuer may fail to make timely payments of interest or principal on a loan.
- Liquidity Risk: This refers to the possibility of buyers being unavailable when security needs to be sold quickly.
- Political Risk: It refers to the potential for adverse government actions or political instability affecting bond issuers, impacting investment returns.
Municipal Bond Offerings: Negotiated vs. Competitive
Two methods by which underwriters can purchase municipal bonds from issuers for public resale: competitive or negotiated sales.
- Competitive: In the competitive method of municipal bond offerings, underwriters bid on bonds at the lowest interest rates in an auction-style process. This promotes transparency and potentially lowers borrowing costs for issuers, benefiting investors seeking favorable terms.
- Negotiated: In negotiated municipal bond offerings, issuers collaborate with underwriters to determine bond terms, including interest rates and issuance structure. This method allows flexibility and tailored solutions but may incur higher borrowing costs than competitive sales.