7 Fixed Income - 7. Fixed Income Explained

Key Concepts

• Fixed Income Securities
• Bonds
• Coupon Rate
• Maturity Date
• Yield to Maturity (YTM)
• Credit Risk
• Duration

Fixed Income Securities

Fixed Income Securities are financial instruments that provide regular interest payments to investors and return the principal amount at maturity. These securities are typically issued by governments, corporations, and other entities to raise capital.

Example: A government bond issued by the U.S. Treasury is a fixed income security that pays periodic interest and returns the principal at maturity.

Bonds

Bonds are a type of fixed income security issued by entities such as governments and corporations. They represent debt obligations where the issuer agrees to pay interest and repay the principal amount at a specified future date.

Example: A corporate bond issued by a company promises to pay a fixed interest rate every six months and return the principal amount at the end of 10 years.

Coupon Rate

The Coupon Rate is the annual interest rate paid on a bond, expressed as a percentage of its face value. It determines the periodic interest payments made to bondholders.

Example: A bond with a face value of $1,000 and a coupon rate of 5% pays $50 in interest annually ($1,000 * 5%).

Maturity Date

The Maturity Date is the date on which the bond issuer is required to repay the principal amount to the bondholder. Bonds can have varying maturities, from short-term (less than one year) to long-term (30 years or more).

Example: A 10-year bond issued in 2023 will mature in 2033, at which point the bondholder will receive the principal amount.

Yield to Maturity (YTM)

Yield to Maturity (YTM) is the total return anticipated on a bond if it is held until it matures. It considers the current market price, coupon payments, and the time value of money.

Example: If a bond with a $1,000 face value and a 5% coupon rate is currently trading at $950, the YTM will be higher than the coupon rate due to the discount from the face value.

Credit Risk

Credit Risk is the risk that the bond issuer may fail to make timely interest payments or repay the principal at maturity. It is often measured by credit ratings provided by agencies like Moody's and Standard & Poor's.

Example: A bond with a high credit rating from a reputable agency is considered less risky, while a bond with a low credit rating carries a higher probability of default.

Duration

Duration measures the sensitivity of a bond's price to changes in interest rates. It provides an estimate of how much the bond's price will change if interest rates fluctuate.

Example: A bond with a duration of 5 years will experience a 5% change in price for every 1% change in interest rates. If interest rates rise by 1%, the bond's price will decrease by approximately 5%.