What is Fixed Income and Analysis?
Fixed income analysis is the study of financial securities with a fixed interest rate. The duration of the loans are not flexible, as they are for floating-rate securities. Fixed-income analysis falls on a spectrum depending on its level of complexity. At one end it can be as simple as calculating the return on a bond and at the other end it can involve constructing a complete credit portfolio. Fixed income analysis according to Fintalent’s fixed income analysis consultants involves making decisions about whether to invest in individual bonds or diversify holdings across bonds with different maturities, issuers, and credit ratings.
Fixed-income financial instruments (bonds, notes, and CDs) often have maturities of several years. The term duration is used to describe their maturity and the interest rate lags by one or more years behind the date for payment. The return received on a bond depends upon its market price at the time of purchase and the interest rate it pays at maturity. As of December 31, 2006, global government debt securities outstanding were valued at $34 trillion with a weighted average (all maturities/principal amounts) coupon or interest rate of 5.19%. Non-U.S. government debt securities totaled $13 trillion with a weighted average coupon of 2.95%.
The value of any financial instrument (bond) depends on the prevailing interest rates and credit quality of the issuer. The longer the maturity, the lower its price premium is. Generally speaking, securities with a fixed yield date are riskier than those with floating (discounted) yields. Many fixed income instruments pay a coupon that is fixed irrespective of current market prices. This usually reflects a government security with a fixed coupon rate determined by law or policy. Some are set by the issuing agency such as pari-mutuel wagering tax collections in North Carolina. The Treasury Department also issues variable coupons for U.S. federal government debt instruments.
Bonds with a fixed interest rate and fixed payments can be thought of as paying a coupon rate. The price of a bond will be sensitive to any change in the interest rate environment. A change in interest rates that causes market participants to reassess the potential value of bonds will result in changes to their prices. A change in prices that is consistent with what investors would have expected given the changes in interest rates will cause no reaction from the financial markets, except for possible profit taking. When investors have difficulty predicting what future interest rates might bring about, there is more likely to be a reaction from the market. The changes in prices may be positive or negative given the amount of uncertainty.
For instance, if an investor believes that interest rates are going to rise in the future, then he/she may anticipate being better off purchasing a bond with a lower fixed interest rate. This is because the value of the bond will fall as interest rates rise and its yield-to-maturity will become more attractive. On the other hand, if an investor thinks that it is more likely that interest rates will fall in the future, then he/she may anticipate being better off purchasing a bond with a higher fixed rate of interest. This is because its price will increase as interest rates fall and its yield-to-maturity will become more attractive.
When interest rates change and the value of a bond changes in a way that is consistent with what investors would have expected given the changes in interest rates, then the bond will be said to be very “interest rate sensitive”. Bonds that are very interest rate sensitive go down in price when rates rise, and they go up in price when rates fall. This can be called “normal” sensitivity. However some bonds may become more sensitive to changes in interest rates than normal. They do not go up or down as much as they should given the amount of change in interest rates. Investors sometimes call this “negative convexity. “
The more negative convexity a bond has, the greater the likelihood that it will be affected by an interest rate change. Bonds with low negative convexity are often called “inverted yield curve” bonds. They have little or no sensitivity to changes in interest rates. The most important example of inverted yield curve bonds are Zero Coupon Bonds. These are issued at prices below face value and they start paying interest (their coupon payment) at maturity. Because they do not pay any interest prior to their maturity date, they have no price sensitivity to changes in market interest rates.
The purpose of this type of security is to allow investors to react to changes in interest rates without spending time forecasting the direction of the market. Zero Coupon (ZC) bonds are seen by many as a “primitive” or “naive” form of derivatives. These instruments have no coupons, but they do have an option embedded into them. The investor has the choice to hold them until maturity, which is similar to buying a call option on the underlying asset. If you buy a stock that pays dividends and it starts paying larger dividends then you would want to sell the stock before those dividends increase further because your current price is less than its intrinsic value. So you sell a call option on the dividend paying stock, which allows you to sell it before the next dividend.
The most important relationship in calculating a bond’s price is between its yield to maturity and its price. One of the key rules of bond pricing is that the discounted value of any fixed-income security equals its yield to maturity. This relationship is known as “the YTM rule. ” Up until late 2007 the yield to maturity levels in most developed markets were quite high. This is why it was relatively easy for market participants in those countries to make a prediction about the future value of interest rates and adjust their bond prices accordingly.
However, by late 2007, rising volatility in global financial markets caused a number of developed market yields to fall significantly and therefore make it harder for bond traders to predict the future direction of interest rates. Some investors took advantage of this environment by selling or shorting bond futures contracts on very short maturities such as 1 month or less.
These markets were driven by speculators and other non-professional investors that traded on their “gut feelings” about future interest rate movements. The price of these extremely short-term instruments are determined using advanced methods.
The purpose of the Sudden Stop Put Option is to make trades that would not be feasible with a longer maturity instrument or in an outright futures contract. This is because short maturities tend to be more volatile than long maturities, and this makes it very difficult to accurately predict the direction of rates in shorter term instruments like options. In addition, the returns are less predictable because they are much less liquid and under-theorized compared to longer term instruments like a bond or futures contract. Therefore the Sudden Stop Put Option has historically been very risky and it has often led to large losses for investors due to its low return.
The coupon payments on bonds sold at a price below face value are known as “yields in suspension”, and they represent the market interest rate. These coupons are called “coupon payments” on bonds that have no or little interest. If an investor purchases a bond with a face value of $1,000, then he/she will receive only $100 worth of cash if he/she holds the bond until maturity. The remaining $900 in value represented by the coupon is called a “yield in suspension”. Over the next 32 months, this coupon will accumulate interest at a rate of $100 per year. After one year the value of this bond will be $1,400 ($1,100 plus $200 in interest). This accrual is called the “nominal yield. ” However, investors would rather receive cash at time of maturity than receive more interest payments.
The value of a bond that possesses its coupon income in the form of cash flows at maturity is known as its “synthetic constant dollar price” or its “CDP” (for Constant Dollar Price). The most common synthetic constant dollar price is the one that represents actual cash flows in U.S. dollars or Canadian dollars, or even British pounds or Euros. The constant dollar price is the amount of cash that would be received if the bond’s coupon payments were held in a bank account for 28 years with no change in interest rates. However, these prices are only useful for making comparisons across different bonds.
Bonds are traded on an exchange in what is called “bond auctions”, which are conducted by dealers who buy and sell bonds as part of their normal business activity. When a bond auction is conducted, it costs a fee to participate in the process. The winner bidder pays the seller of the bond and then receives a bond in payment. The bond winner is called a “taker”. If there are multiple bidders, then the one that pays the lowest price is called a “taker” and it will receive the highest grade (highest quality) bond available for auction. If more than one bond is auctioned, then it is usually possible to price them similar to each other by auctioning them all together.
If there are no takers for an auction of bonds, then there will not be any price offered nor any bonds awarded. This can occur if there are not enough sellers or buyers to make the process seem like a good idea to someone else. This means that there is an opportunity cost associated with not using the auction process. Bids can be placed on bonds up to 45 minutes before the start of the auction, but there is no advantage to being first. The auction can be repeated if there was not enough interest from those who were willing to invest in the auction.
However, if the process is repeated, then it becomes possible for some large investors or traders to take advantage of bids and close out their positions before others do so. This is called “closing out” one’s position or “closing a position”. There is no limit on how many times a bond can be closed out.
