Fixed income analysis
Fixed income analysis is the valuation of fixed income or debt securities, and the analysis of their interest rate risk, credit risk, and likely price behavior in hedging portfolios. The analyst might conclude to buy, sell, hold, hedge or stay out of the particular security.
Fixed income products are generally bonds issued by various government treasuries, companies or international organizations. Bond holders are usually entitled to coupon payments at periodic intervals until maturity. These coupon payments are generally fixed amounts (quoted as percentage of the bond's face value) or the coupons could float in relation to LIBOR or another reference rate.
Valuation
The cash flow of a fixed income product generally consists of several coupon payments over the period of the bond's life, and repayment of the principal at the time of maturity. Since these cash flows occur at several times in the future, the "Time Value of Money" approach is used to find the "Present Value" of each cash flow. The sum of all the present values of the bonds cash inflows of the bond is its theoretical value.
Following are the typical questions an analyst finds answers for:
- Does the real interest rate built into the yield make sense?
- Is the real interest rate in line with the expected GDP growth rate (in case of treasury bonds) or earnings growth rate (in case of corporate bonds)?
- What is the expectation of GDP growth ? Where do we stand in the economy cycle?
- Where do we stand in the business cycle of the particular company, or economic cycle of the particular country?
- Is there any change expected in the basic real interest rate in the near future?
- Do the prevailing monetary and economic conditions force any monetary easing or tightening so that the base real rate will get changed?
- Is the inflation condition worsening or improving?
- Are the financial authorities in the country pro-acting or re-acting to the forces of inflation and economic conditions?
- Is the risk premium built into the yield enough to compensate for the risks?
- What are the likely risks the market has currently priced into the premium and what are the new or hidden risks the market has overlooked and to what extent?
- What is the nature and volume of demand for a particular bond?
The demand for fixed income products comes from banks, insurance companies, pension fund companies, endowment organisations, External Government Treasuries, individual investors like retirees who need regular fixed cash in-flow.
The Fixed Income Analyst covers the term structure or yield curve analysis too. This is in simple terms, analysing all bonds issued by the same entity for different maturities (like US Govt 2yr bond, 10yr bond, 20 year bond). Such analysis enables one to understand the pricing differences between maturities comparable inter-market bonds (like Eur 2yr, 5yr and 10yr bunds)
The approaches for analysing fixed income products are broadly as follows: Fundamental approach; Technical Approach; relative value Approach.
Further reading
- Dr Andrew Colin "Fixed Income Attribution" (London, Wiley & Sons. January 2005) ISBN 978-0-470-01175-1