Module 8: Fixed Income
Fixed income securities are financial instruments that provide investors with regular interest payments and repayment of principal at maturity. These securities are widely used by governments, corporations, and financial institutions to raise capital.
Investors purchase fixed income securities to earn stable income and diversify their investment portfolios. Compared to equities, fixed income investments generally offer lower risk and more predictable cash flows.
The most common fixed income securities include bonds issued by governments, corporations, and municipalities.
This module introduces the characteristics of fixed income securities, bond valuation techniques, interest rate risk measures, and credit risk analysis.
Fixed income securities have several key characteristics that determine their value and risk profile.
Face Value
Face value, also known as par value, is the amount that the issuer agrees to repay the bondholder at maturity.
Most bonds have a face value of 1000, although this may vary depending on the issuer and market.
Coupon Rate
The coupon rate represents the annual interest payment made to bondholders.
Coupon Payment Formula
Annual Coupon Payment = Face Value × Coupon Rate
For example, if a bond has a face value of 1000 and a coupon rate of 6 percent, the annual interest payment will be 60.
Maturity Date
The maturity date is the date when the issuer repays the principal amount to the bondholder.
Bonds may have different maturities such as:
Short term bonds (less than 3 years)
Medium term bonds (3 to 10 years)
Long term bonds (more than 10 years)
Issuer
Bonds can be issued by different entities, including:
Government bonds
Issued by national governments.
Corporate bonds
Issued by companies to finance business operations.
Municipal bonds
Issued by local governments.
The value of a bond is determined by discounting its future cash flows, which include periodic coupon payments and repayment of principal.
Bond Price Formula
Bond Price = Present value of coupon payments + Present value of face value
More specifically:
Bond Price = C/(1+r)^1 + C/(1+r)^2 + … + C/(1+r)^n + FV/(1+r)^n
Where
C = coupon payment
FV = face value
r = required rate of return
n = number of periods
Bond Price and Interest Rates
Bond prices and interest rates have an inverse relationship.
When interest rates increase, bond prices decrease.
When interest rates decrease, bond prices increase.
This relationship occurs because new bonds issued in the market reflect current interest rates.
Yield measures represent the return an investor earns from holding a bond.
Several yield measures are commonly used in fixed income analysis.
Current Yield
Current yield measures the annual income generated by the bond relative to its market price.
Current Yield Formula
Current Yield = Annual Coupon Payment / Bond Price
Example
If a bond pays 60 annually and the bond price is 950, the current yield is approximately 6.32 percent.
Yield to Maturity (YTM)
Yield to maturity represents the total return an investor will earn if the bond is held until maturity.
YTM considers:
- coupon payments
- capital gain or loss
- time remaining to maturity
YTM is the most widely used measure of bond returns.
Yield to Call
Some bonds allow the issuer to repay the bond before maturity.
Yield to call measures the return assuming the bond is called before maturity.
The term structure of interest rates describes the relationship between bond yields and their maturity periods.
This relationship is commonly represented by the yield curve.
Types of Yield Curves
Normal Yield Curve
Long term interest rates are higher than short term rates.
Inverted Yield Curve
Short term rates are higher than long term rates.
Flat Yield Curve
Short term and long term rates are similar.
Yield curves provide insights into economic expectations and future interest rate movements.
Duration and convexity measure the sensitivity of bond prices to changes in interest rates.
Duration
Duration measures how much a bond’s price changes when interest rates change.
Approximate Price Change Formula
Percentage Change in Bond Price = − Duration × Change in Interest Rate
Key observations:
- Bonds with longer maturity have higher duration.
- Bonds with lower coupon rates have higher duration.
Higher duration means greater interest rate risk.
Convexity
Convexity measures the curvature of the relationship between bond prices and interest rates.
It improves the accuracy of bond price estimates when interest rates change significantly.
Bonds with higher convexity experience less price decline when interest rates rise and greater price increase when interest rates fall.
Credit risk refers to the possibility that the bond issuer may fail to make interest payments or repay the principal.
Investors must evaluate the creditworthiness of bond issuers before investing.
Credit Ratings
Credit rating agencies evaluate the financial strength of issuers and assign credit ratings.
Major rating agencies include:
- Standard and Poor’s
- Moody’s
- Fitch
Ratings typically range from high quality investment grade bonds to high risk speculative bonds.
Investment Grade Bonds
Investment grade bonds have relatively low default risk.
These bonds are considered safer investments.
High Yield Bonds
High yield bonds, also known as junk bonds, offer higher interest rates to compensate investors for higher risk.
These bonds are issued by companies with weaker financial profiles.
Credit Spread
Credit spread represents the difference in yield between a corporate bond and a government bond of similar maturity.
Higher credit spreads indicate higher perceived credit risk.
Fixed income securities play an important role in investment portfolios because they:
- provide stable income
- reduce portfolio volatility
- offer diversification benefits
- help preserve capital
They are commonly used by pension funds, insurance companies, and conservative investors seeking predictable returns.