Treat every debt securities question as three separate numbers: the coupon (fixed at issue), the price (observed in the market) and the yield (solved from the other two). Then pick the risk measure that matches the question: duration for interest-rate moves, credit spread for corporate paper, reinvestment assumptions for horizon returns. Verify each rule numerically on a small pricing grid rather than memorising slogans; the self-check rubric below confirms price-yield inversion, convexity asymmetry and duration rankings before you sit the exam.
Coupon rate is not your return: separating coupon, price and yield
The coupon is a fixed contractual payment; the return you actually earn depends on the price you pay and the yield at which future cash flows are discounted. Keep these three concepts distinct from your first study session onward.
Define each term precisely. The coupon rate is the annual coupon divided by face value, fixed when the instrument is issued. The current yield is the coupon divided by the market price, so it moves with the price. Yield to maturity is the single discount rate that equates the price to the present value of all remaining cash flows. For a standard fixed-coupon bond with no embedded options, a bond trading below par has a current yield above its coupon and a yield to maturity above the current yield; the ordering reverses for a premium bond, and all three coincide at par.
The same three-way distinction applies across the instruments in Sri Lankan syllabus material, from government securities issued through the central bank to corporate debentures listed on the exchange. Turn it into a reflex: for every question, label which number is fixed, which is observed and which is being solved for. For example, a 10% coupon debenture bought at 95 has a current yield above 10% and a yield to maturity above that current yield. If you cannot state the ordering instantly, that is the gap to close first.
Pricing under a yield shift: a worked scenario with a common misstep
Price is the present value of coupons and principal discounted at the market required yield, not the coupon rate. A yield change moves the price in the opposite direction, and the size of that move depends on the bond's coupon and maturity.
Worked scenario: a 3-year bond with face value 100 and a 10% annual coupon, where the market required yield is 12%. The plausible mistake is discounting the cash flows at the 10% coupon rate, which produces exactly 100 and suggests the bond is fairly priced at par. The better decision is to discount at the 12% required yield: 10/1.12 = 8.93, 10/1.12 squared = 7.97, and 110/1.12 cubed = 78.30, giving a price of about 95.20. Why it matters: the coupon rate merely describes the cash flows; the required yield is the market's pricing input, and confusing them makes a discount bond look fairly valued.
Now invert the same example to connect the three measures. At 95.20, the bond's yield to maturity is 12% and its current yield is 10/95.20, roughly 10.5%, so the ordering runs yield to maturity, then current yield, then coupon. That ordering is the signature of a discount bond; it reverses for a premium bond and collapses to a single number at par. As a quick exercise, reprice the same bond at an 8% required yield: you should get about 105.15, confirming that price falls as yield rises and that the discount has become a premium.
Duration versus maturity: why two five-year bonds are not equally risky
Maturity measures time to principal repayment; duration measures the weighted average time to receive all cash flows and approximates price sensitivity to yield changes. Lower coupons stretch duration, higher coupons shorten it.
Worked scenario: two bonds, both with 5 years to maturity and a 10% required yield. Bond A is a zero-coupon bond priced near 62.09; Bond B pays a 10% annual coupon and trades at par, 100. The plausible mistake is treating both as identical five-year exposure and sizing positions equally. If the yield rises to 11%, Bond A drops to about 59.35, a loss of roughly 4.4%, while Bond B falls to about 96.30, a loss of roughly 3.7%. The better decision is to compare Macaulay durations before sizing: about 5.0 for the zero-coupon bond against about 4.2 for the coupon bond. Why it matters: matching maturity labels hides materially different rate sensitivities, which changes both position sizing and hedging choices.
Convert Macaulay duration to modified duration by dividing by one plus the yield per period; modified duration estimates the percentage price change for a unit change in yield. Verify these relationships numerically rather than memorising them: longer maturity raises duration, lower coupon raises duration, and lower yield raises duration slightly, while a zero-coupon bond's duration equals its maturity. When a question presents two bonds and asks which falls more if yields rise, rank durations instead of scanning the maturity column. Where a question gives modified duration directly, estimate the price impact as negative duration times the yield change for small shifts.
Matching instrument to objective: Treasury bills, Treasury bonds and listed debentures
Government short-term paper, government bonds and corporate debentures differ in issuer, income pattern and dominant risk. Match the instrument to the question's objective, whether liquidity, income stability or credit exposure, before comparing headline returns.
Treat instrument identification as a decision, not trivia. Treasury bills are short-term government paper issued at a discount and redeemed at face value, with no coupon, so their return comes entirely from the discount. Treasury bonds pay fixed periodic coupons and repay principal at maturity, so they carry interest-rate risk and reinvestment risk. Corporate debentures listed on the exchange offer fixed or floating coupons but shift the dominant concern to the issuer's creditworthiness and secondary-market liquidity. Repos are collateralised short-term transactions whose return is the difference between the sale and repurchase prices.
In the Sri Lankan setting, the regulatory frame matters for how these instruments sit together: the Securities and Exchange Commission Act No. 19 of 2021 is the current statute governing securities regulation, having replaced the earlier Acts, and listed corporate debt falls within the SEC's disclosure and oversight regime. When a question describes a saver who needs short-term parking of funds, a retiree seeking steady coupons, or an investor weighing a higher corporate yield against a government benchmark, first name the dominant risk of each candidate instrument and only then compare returns. The table below is a compact version of that reasoning to memorise by structure, not by rote.
| Instrument | Issuer | Income pattern | Typical tenor | Risk to track first |
|---|---|---|---|---|
| Treasury bills | Government, issued via the central bank | Discount to face value, redeemed at par, no coupon | Short | Rollover at changed short-term rates |
| Treasury bonds | Government, issued via the central bank | Fixed periodic coupons plus principal at maturity | Medium to long | Interest-rate and reinvestment risk |
| Listed corporate debentures | Corporates, exchange-listed | Fixed or floating coupons | Medium to long | Issuer credit risk and liquidity |
| Repos | Counterparty, collateralised | Difference between sale and repurchase price | Very short | Collateral quality and counterparty performance |
Reading credit ratings and spreads as relative signals, not answers
A credit rating is an independent opinion on an issuer's ability to meet its obligations, not a guarantee. In Sri Lanka, rating agencies operate within an SEC-registered framework; spreads compensate for credit risk relative to a benchmark.
A spread is the extra yield a corporate instrument offers over a comparable government benchmark. Decompose any gap before interpreting it: part reflects credit risk, part liquidity, and part any embedded features such as a call option. Ratings can be upgraded or downgraded, and agencies commonly place issuers on watch when conditions change, so a rating is a snapshot judgment that can move. Sri Lanka's SEC oversees credit rating agencies as registered market participants, which is why a rating can be cited in exam answers as an external credit opinion rather than issuer marketing.
Mini-scenario: a listed debenture yields 12% while a Treasury bond of similar tenor yields 10%. The plausible mistake is reading the two-point gap as a free improvement in return. The better decision is to ask which risk the gap compensates: the corporate issuer's default probability, thinner secondary trading, or a callable structure that caps upside for the holder. Why it matters: if the extra yield is compensation for credit and liquidity, the investor is being paid to bear those risks, and a downgrade or an illiquid market can erase the advantage. Practise writing one sentence per spread component before comparing instruments in practice questions.
Reinvestment risk and the yield curve: what yield to maturity quietly assumes
Yield to maturity assumes coupons are reinvested at the same rate and the bond is held to maturity. When rates fall, realised return drops below the quoted YTM; the yield curve's shape changes how horizon returns behave.
The reinvestment assumption is the quiet weak point of yield to maturity. A coupon bond returns cash periodically, and those coupons must be reinvested somewhere; if reinvestment rates are lower than the purchase YTM, the realised compound return falls short of the quoted figure. A zero-coupon bond avoids reinvestment risk because it pays nothing until maturity, but it concentrates interest-rate risk instead, which links back to the duration comparison earlier. When a question describes an investor with a fixed horizon or a falling rate environment, the tested concept is the gap between promised yield and realised return, not the quoted YTM itself.
Distinguish yield to maturity from spot rates. A single YTM discounts every cash flow at one rate; spot rates discount each cash flow at the rate appropriate to its own maturity. Exercise: price a 3-year bond with a 10% annual coupon using spot rates of 8%, 9% and 10% for the first, second and third years; discounting 10 at 8%, 10 at 9% squared and 110 at 10% cubed gives roughly 100.3, which differs from any single-YTM price. An upward-sloping set of spot rates signals a rising curve, and questions about expectations, horizon returns or curve shape require spot-rate reasoning, not a flat single rate.
A two-week practice sequence with a self-check rubric
Spend the first week building and repricing one bond grid by hand, and the second applying duration, spread and reinvestment logic to mixed questions. Track your work against the observations below rather than a single score.
Suggested sequence, adaptable to your calendar. Days one to three: build a pricing grid for one hypothetical 3-year, 10% annual-coupon bond and recompute the price at required yields of 8%, 10% and 12%. Days four and five: add a 5-year zero-coupon bond and a 5-year 10% coupon bond, compute Macaulay and modified durations, and rank their price sensitivity. Days six and seven: use the instrument table to match instruments to short investor scenarios. Week two: shift to mixed question sets covering ratings and spreads, spot-rate pricing and reinvestment assumptions, finishing with timed review using the site's free practice bank so the concepts surface under time pressure.
Readiness checks: you should be able to price any fixed-coupon bond at an arbitrary required yield by hand within a few minutes; state the ordering of coupon, current yield and yield to maturity for premium, discount and par bonds without hesitation; rank two bonds by price sensitivity using duration logic rather than the maturity column; explain in two sentences why realised return can differ from yield to maturity; and map every instrument in the table to its dominant risk. These are learning milestones to confirm understanding, not predictions of any passing outcome.
- Price moves inversely with yield in every recomputation of the grid.
- Equal upward and downward yield changes produce slightly unequal price changes, with the gain from a yield fall exceeding the loss from an equal rise; that asymmetry is convexity.
- For the same yield shift, the zero-coupon bond's price change exceeds the coupon bond's, matching their duration ranking.
- The discount-bond ordering of yield to maturity above current yield above coupon holds in every discount row and reverses in every premium row.
- Spot-rate pricing differs from single-YTM pricing, with the gap shrinking for short tenors and gently sloped curves.
References and further reading
Use these references to explore the concepts and check the latest information from the relevant organizations.