What it means
A fixed income instrument is simply a loan in tradable form. The investor hands over cash today and receives a schedule of interest payments (called coupons) plus the return of the original amount (the principal) at a stated maturity date.
The reason analysis is needed at all is that the price of a bond moves even though its payments do not. If market interest rates rise after you buy, your fixed coupon looks less attractive and the price falls; if rates fall, the price rises.
Analysts measure this sensitivity using duration, which estimates the percentage price change for a 1% move in rates. The second pillar is credit.
A borrower who might not pay must offer a higher yield to compensate, and the gap between that yield and a government bond of the same maturity is called the credit spread. Analysts study cash flow cover, leverage and loan conditions to judge whether that spread is generous or thin.
In a business context, fixed income analysis shapes both sides of the balance sheet. Treasury teams use it to decide where to place surplus cash and how to price a new bond issue, while finance leaders use it to understand what the market currently thinks of their own creditworthiness.
A common variant is relative value analysis, which compares two similar bonds and asks which offers more yield for the same risk. Another is scenario analysis, where a portfolio is repriced under several interest rate paths so the potential loss is visible before it happens rather than afterwards.
In practice
Real-world examples.
Example
A logistics company with $12,000,000 of surplus cash asks its treasurer to place the money for two years. She compares a government note yielding 4.2% with a corporate bond yielding 5.6%, decides the 1.4% spread does not compensate for the issuer's weak interest cover, and buys the government note instead.
Example
A pension fund analyst is asked why the fund lost value in a quarter when not a single borrower defaulted. She shows the trustees that the portfolio's duration was 7, so a 0.5% rise in market interest rates translated into roughly a 3.5% fall in value with nothing else changing.
Example
A software firm preparing its first bond issue hires bankers to analyse where comparable issuers trade. They conclude that the market will demand a spread of about 3% over government bonds, so the company sets its coupon accordingly and raises $250,000,000 at a cost it can defend to its board.
Think of it
“Fixed income analysis is studying bonds-figuring out which debt securities are good investments.
Formula
Calculation
Current Yield = Annual Coupon Payment / Current Market Price
Approximate Yield to Maturity = (Annual Coupon + (Face Value - Price) / Years to Maturity) / ((Face Value + Price) / 2)
Worked example: a corporate bond has a face value of $1,000, pays a 6% coupon, has five years left to maturity and currently trades at $800.
Annual coupon = 6% of $1,000 = $60.
Current yield = $60 / $800 = 0.075, or 7.5%.
Capital gain if held to maturity = $1,000 - $800 = $200, spread over 5 years = $40 a year.
Numerator = $60 + $40 = $100.
Average of face value and price = ($1,000 + $800) / 2 = $900.
Approximate yield to maturity = $100 / $900 = 0.1111, or about 11.1%.
The bond pays 7.5% in cash each year, but the pull back towards face value at maturity lifts the total expected annual return to roughly 11.1%. An analyst would then ask why the market is demanding that much, which usually points straight at the issuer's credit risk.Case study
Seen in the real world.
Ravensworth Pension Trust is an illustrative, entirely fictional retirement scheme used here to show fixed income analysis in action. Its trustees held a portfolio of long-dated corporate bonds bought years earlier because the coupons looked attractive, and nobody had reassessed them since.
A new investment adviser ran the basic analysis. Duration across the portfolio was just over 11, meaning a 1% rise in rates would cost roughly 11% of the portfolio's value, and almost a third of the holdings sat with issuers in a single cyclical industry. The average credit spread on those holdings had narrowed to 1.1%, less than half the level at which they were originally bought.
The trustees agreed to sell the most concentrated positions, shorten average duration to around 6 and reinvest in shorter government-backed paper. When rates rose sharply the following year, the scheme lost far less than it would have done, and the trustees had a written analysis showing why they had acted when they did.
Watch out
Common mistakes.
- Treating the coupon rate as the return. The coupon is fixed against face value, but your actual return depends on the price you paid, so a 6% coupon bought at $800 yields far more than 6%.
- Assuming bonds cannot lose money. A bond held to maturity by a solvent issuer returns face value, but its market value in the meantime can fall a long way when interest rates rise.
- Chasing the highest yield on a screen. An unusually high yield is the market pricing in a real chance the borrower will not pay in full, not a bargain nobody else noticed.
Questions
People also ask.
What is the difference between yield and coupon?
The coupon is the fixed cash payment expressed against face value, while the yield expresses your return against the price you actually paid.
Does duration tell you how long to hold a bond?
No, duration is a sensitivity measure that estimates how much the price moves for a given change in interest rates, even though it is quoted in years.
Is a government bond risk free?
It carries almost no credit risk in a stable currency, but it still carries interest rate risk and inflation risk, both of which can reduce your real return.
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