💲Intro to Investments Unit 7 – Fixed Income: Characteristics & Valuation

What's Fixed Income All About?

• Fixed income securities provide investors with a predictable stream of income payments over a specified period
• Issuers of fixed income securities borrow funds from investors and make regular interest payments until the maturity date, at which point the principal is repaid
• Fixed income investments generally offer lower risk and lower potential returns compared to equity investments
• Common types of fixed income securities include government bonds, corporate bonds, and municipal bonds
• Fixed income plays a crucial role in diversifying investment portfolios and managing risk
• Investors in fixed income securities are essentially lending money to the issuer in exchange for interest payments and the return of principal
• The creditworthiness of the issuer is a key factor in determining the interest rate and risk associated with a fixed income security

Types of Fixed Income Securities

• Government bonds issued by national governments (U.S. Treasury bonds) are considered low-risk investments due to the backing of the government
• Corporate bonds issued by companies to raise capital for various purposes such as expansion, acquisitions, or refinancing debt
  • Corporate bonds typically offer higher yields than government bonds but carry more credit risk
• Municipal bonds issued by state and local governments to fund public projects (infrastructure development)
  • Interest earned on municipal bonds is often exempt from federal income taxes and sometimes state and local taxes
• Asset-backed securities (ABS) are bonds backed by a pool of assets such as mortgages, car loans, or credit card receivables
• Mortgage-backed securities (MBS) are a type of ABS where the underlying assets are residential or commercial mortgages
• Zero-coupon bonds do not make regular interest payments but are instead sold at a discount to their face value, with the investor receiving the full face value at maturity
• Convertible bonds give bondholders the right to convert their bonds into a specified number of shares of the issuer's common stock

Key Features of Bonds

• Face value (par value) represents the amount the bondholder will receive at maturity and is used to calculate interest payments
• Coupon rate is the annual interest rate paid by the issuer, expressed as a percentage of the bond's face value
  • Coupon payments are typically made semi-annually
• Maturity date is the date on which the issuer repays the bondholder the face value of the bond
• Issuer is the entity borrowing funds by issuing the bond, and its creditworthiness affects the bond's risk and yield
• Credit rating assigned by credit rating agencies (Moody's, Standard & Poor's) indicates the issuer's ability to meet its debt obligations
• Callability is a feature that allows the issuer to redeem the bond before maturity, typically when interest rates have fallen
• Putability is a feature that allows the bondholder to sell the bond back to the issuer before maturity, providing protection against rising interest rates

How to Value Bonds

• Bond valuation involves determining the present value of a bond's future cash flows, which include coupon payments and the return of principal at maturity
• The time value of money concept is crucial in bond valuation, as it accounts for the fact that money received in the future is worth less than money received today
• The discount rate used in bond valuation is the required rate of return, which reflects the bond's risk and opportunity cost
• The bond pricing formula calculates the present value of a bond as the sum of the present values of its future coupon payments and the present value of its face value: $Bond Price = \sum_{t=1}^{n} \frac{Coupon}{(1+r)^t} + \frac{Face Value}{(1+r)^n}$
  • $n$ is the number of periods until maturity, $r$ is the required rate of return (discount rate), and $t$ is the time period
• Bond prices have an inverse relationship with interest rates; when interest rates rise, bond prices fall, and vice versa
• Duration measures a bond's sensitivity to changes in interest rates, with higher duration indicating greater price sensitivity
• Convexity is a measure of how the duration of a bond changes as interest rates change, providing a more accurate estimate of bond price changes

Yield Measures and Curves

• Current yield is the annual coupon payment divided by the bond's current market price, expressed as a percentage
• Yield to maturity (YTM) is the total return an investor will receive by holding the bond to maturity, assuming all coupon payments are reinvested at the same rate
  • YTM is calculated using an iterative process that equates the bond's current market price with the present value of its future cash flows
• Yield to call (YTC) is the total return an investor will receive if the bond is called by the issuer before maturity
• Yield curve is a graphical representation of the relationship between bond yields and their time to maturity
  • Normal yield curve slopes upward, indicating higher yields for longer-term bonds
  • Inverted yield curve slopes downward, indicating lower yields for longer-term bonds and is often seen as a sign of an impending economic recession
• Credit spread is the difference in yield between a corporate bond and a government bond of similar maturity, reflecting the additional risk associated with corporate bonds
• Term premium is the additional yield investors require to hold longer-term bonds, compensating for the greater risk and uncertainty associated with longer investment horizons

Risks in Fixed Income Investing

• Interest rate risk is the risk that changes in interest rates will cause bond prices to fluctuate
  • When interest rates rise, bond prices fall, and vice versa
• Credit risk (default risk) is the risk that the bond issuer will fail to make coupon payments or repay the principal at maturity
  • Higher credit risk is associated with lower credit ratings and higher yields
• Inflation risk is the risk that the purchasing power of the bond's cash flows will be eroded by inflation over time
  • Inflation-linked bonds (Treasury Inflation-Protected Securities) offer protection against inflation risk
• Liquidity risk is the risk that an investor may not be able to sell a bond quickly or at a fair price due to limited market demand
• Call risk is the risk that a callable bond will be redeemed by the issuer before maturity, potentially forcing the investor to reinvest at lower interest rates
• Prepayment risk is the risk that borrowers will pay off their loans earlier than expected, typically when interest rates fall, affecting the cash flows of mortgage-backed securities
• Currency risk arises when investing in bonds denominated in foreign currencies, as exchange rate fluctuations can impact the value of the investment

Trading and Market Dynamics

• Fixed income securities are traded in over-the-counter (OTC) markets, where buyers and sellers negotiate directly or through intermediaries such as brokers and dealers
• Bid-ask spread is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask) for a bond
  • Larger bid-ask spreads indicate lower liquidity and higher transaction costs
• Benchmark rates (LIBOR, Treasury rates) serve as reference rates for pricing fixed income securities and derivatives
• Yield spreads between different types of bonds (credit spreads, term spreads) reflect the relative risk and return characteristics of those bonds
• Bond market liquidity can be affected by various factors, including market sentiment, economic conditions, and regulatory changes
• Electronic trading platforms have increased transparency and efficiency in fixed income markets, although OTC trading still dominates
• Bond market indices (Bloomberg Barclays US Aggregate Bond Index) are used to track the performance of various segments of the fixed income market and serve as benchmarks for portfolio management

Fixed Income in Portfolio Management

• Fixed income investments play a crucial role in diversifying investment portfolios and managing risk
• The allocation to fixed income in a portfolio depends on factors such as the investor's risk tolerance, investment goals, and time horizon
• Core fixed income strategies aim to provide stable income and capital preservation by investing in high-quality, investment-grade bonds
• Tactical fixed income strategies seek to capitalize on market inefficiencies and generate excess returns through active management and opportunistic investments
• Liability-driven investing (LDI) is an approach used by institutional investors to match the duration of their assets with their liabilities, minimizing interest rate risk
• Immunization is a fixed income portfolio management strategy that aims to protect the portfolio's value against changes in interest rates by matching the duration of assets and liabilities
• Bond laddering involves building a portfolio of bonds with different maturities to manage interest rate risk and provide a steady stream of income
• Fixed income derivatives (interest rate swaps, futures, options) can be used to hedge interest rate risk or express views on the direction of interest rates