Fixed income securities are financial instruments like bonds, which provide returns in the form of regular (or fixed) interest payments and the return of principal at maturity. In other words, these are financial instruments that pay a fixed amount of interest or dividend income to investors until maturity. Upon maturity, investors are repaid the principal amount invested. Examples include bonds (government, municipal, corporate), treasury bills, and certificates of deposit (CDs).
Yield Calculations
Yield represents the income return on an investment, typically expressed as an annual percentage rate.
- Yield to Maturity (YTM): The total return anticipated on a bond if it is held until maturity. It includes all interest payments and the gain or loss due to the difference between the purchase price and the par value.
- Current Yield: Calculated as the annual interest payment divided by the current market price of the bond.
Yield Curve & Forward Rates
Yield curve is a graph that plots the yields of similar-quality bonds against their maturities, ranging from shortest to longest. The shape of the yield curve is a powerful economic indicator.
- Normal Yield Curve: An upward sloping curve, indicating higher yields for longer maturities.
- Inverted Yield Curve: A downward sloping curve, often seen as a predictor of economic recession.
- Flat or Humped Curve: Suggests transition or mixed economic signals.
- Forward Rates: These are interest rates or yields implied by current market prices for periods in the future. They are derived from the yield curve and are essential in interest rate speculation and fixed-income arbitrage.
- A forward rate is an interest rate applicable to a financial transaction that will take place in the future. It's not a rate available today but is derived from the current yield curve, representing the market's expectation of future interest rates. Forward rates are used to understand market expectations about future interest rates and to hedge against interest rate risk.
Duration
Duration is a measure used in fixed income securities to determine the sensitivity of a bond's price to changes in interest rates. It's an essential concept for managing interest rate risk. There are two types of durations:
- Macaulay Duration: This is the weighted average time until a bond's cash flows are received. It's calculated by weighting the present value of each cash flow by the time until receipt and then summing these values. Macaulay duration is expressed in years.
- Modified Duration: This measures the price sensitivity of a bond to interest rate changes and is derived from the Macaulay duration. Modified duration indicates the percentage change in a bond's price for a 1% change in interest rates.
Duration helps investors understand and manage the risk posed by changing interest rates. Bonds with longer durations are more sensitive to interest rate changes. By understanding the duration of bonds, investors can structure their bond portfolios to match their interest rate risk appetite or to hedge against interest rate changes.
Swaps
Swaps are financial derivatives used to exchange cash flow obligations between two parties. They are commonly used for hedging risk or speculating on changes in market conditions. The most common types are interest rate swaps and currency swaps, though there are various other types like commodity swaps or credit default swaps.
- Interest Rate Swaps: These involve exchanging interest payment obligations. The most common type is the exchange of a fixed interest rate for a floating rate, or vice versa. Companies often use interest rate swaps to manage exposure to fluctuations in interest rates.
- For example, a company with a variable-rate loan might use a swap to fix its interest costs.
- Company A might pay a fixed rate to Company B, while Company B pays a variable rate to Company A. The variable rate is usually pegged to a benchmark like the LIBOR (London Interbank Offered Rate).
- Currency Swaps: In currency swaps, two parties exchange principal and interest in different currencies. The principal amounts are usually exchanged at both the start and end of the agreement. Currency swaps are used to secure cheaper debt (by borrowing at the best available rate in any currency) and to hedge against currency risk.
- For example, a U.S. company might swap dollars for euros with a European company. They would exchange interest payments periodically and then re-exchange the principal amounts at the end of the term.
Key features of Swap:
- Customization: Swap agreements can be highly customized to suit the specific needs of the counterparties, including the amount, term, and frequency of payments.
- Counterparty Risk: Since swaps are private agreements, there's a risk that one party may default. This risk is called counterparty risk.
- No Exchange of Principal in Interest Rate Swaps: In standard interest rate swaps, the principal amounts are not actually exchanged. Only interest payment obligations are swapped.
- Valuation: The value of a swap is determined by the present value of the expected future cash flows. This value can fluctuate over time with market conditions.
Swaps are crucial for managing risks associated with interest rate fluctuations, currency exchange rate volatility, and other financial variables. Some investors use swaps to speculate on changes in interest rates, currency exchange rates, or other financial metrics. Companies use swaps as tools for financial management, often to align cash flows with anticipated revenues or expenses in a specific currency or to manage debt obligations more effectively.
Risk & Term Structure of Interest Rates
- Interest Rate Risk: The risk that changes in interest rates will negatively affect the value of fixed-income securities.
- When interest rates rise, the value of existing bonds falls, and vice versa.
- Because future (newer) bonds will issue higher yield (higher interest)
- The concept of 'duration' is often used to measure a bond's sensitivity to interest rate changes. Longer-duration bonds are typically more sensitive to interest rate changes than shorter-duration bonds.
- Credit Risk: The risk that a bond issuer will default on its payment obligations.
- Bonds are often rated by credit rating agencies based on the issuer's creditworthiness. Higher-rated bonds (like AAA-rated) have lower credit risk compared to lower-rated (like BBB-rated or junk bonds).
- Term Structure of Interest Rates: This describes the relationship between interest rates (or yields) and the term to maturity. It is often represented by the yield curve, shows the relationship between interest rates or bond yields and different terms to maturity. The theories explaining the term structure include the Expectations Theory, Liquidity Preference Theory, and Market Segmentation Theory.
- Expectations Theory: Suggests that long-term interest rates can be predicted based on current and expected future short-term interest rates. It posits that the yield curve reflects the market's expectations of future short-term rates.
- Liquidity Preference Theory: Proposes that investors demand a higher interest rate or yield for longer-term investments, which are less liquid and have more risk than shorter-term investments.
- Market Segmentation Theory: Suggests that the market for loans is segmented on the basis of maturity, and the supply and demand in each segment determine its prevailing interest rate, independent of other segments.
Additional Concepts
- Callable and Puttable Bonds: Bonds with features that allow the issuer to redeem (callable) or the bondholder to sell back (puttable) the bond before maturity.
- Callable Bonds: These bonds give the issuer the right to redeem (or "call") the bond before its maturity date, often at a set price. Callable bonds are typically called when interest rates drop, allowing the issuer to refinance at a lower interest rate.
- Puttable Bonds: These bonds give the bondholder the right to sell (or "put") the bond back to the issuer before maturity, often at a predetermined price. This feature provides protection to the bondholder against a rise in interest rates or a decline in the issuer's creditworthiness.
- Zero-Coupon Bonds: Zero-coupon bonds do not pay periodic interest. Instead, they are issued at a significant discount to their face value and mature at par (or face value).
- The bond's value accrues over time, with the investor receiving the face value at maturity. The difference between the purchase price and the face value represents the interest earned.
- Zero-coupon bonds are highly sensitive to changes in interest rates, making them more volatile than standard coupon bonds.
댓글