Fixed Income Analysis

Fixed income analysis is the process of evaluating and analyzing fixed income securities for investment purposes.

Fixed Income represents a distinct asset class. Investors and analysts perform fixed-income analysis to

  • Evaluate the risk characteristics underlying debt securities and to assess the capacity of the borrowing entity to meet its financial obligations (credit analysis)
  • Identify which debt securities represent attractive investment opportunities
  • Determine the appropriate valuation (or value) of debt securities in the market
  • Compare the investment characteristics (e.g., risk and return) of debt securities with each other and with other asset classes such as stocks, derivatives, real estate, or other.

Features and Characteristics of Fixed Income

Some important features of fixed income securities include

  • Government versus Corporate Bonds
    • On a very broad level, fixed income securities can be categorized as
      • Government
        • E.g., US Treasuries
    • Corporate
      • Bonds issued by public corporations
      • Issuer
        • The party, entity, or corporation that sells the debt obligation to investors
        • This is the borrowing entity
        • Borrower or Debt Security Holder
          • The party that has purchased the debt obligation (i.e., the lender)
          • Principal or Face Value
            • The amount borrowed which has to be repaid in full at a future date
            • Interest
              • The interest rate that is applied to the principal borrowed amount
              • Periodic Payments
                • The periodic dates during the life of the debt for which the borrower is responsible for making regular payments of interest or principal (or both)
                • Maturity
                  • The length of time from the inception of the debt to its termination
                  • Fixed-Income Options
                    • Options embedded within fixed income securities giving the lender or borrower the right to either redeem the obligation
                      • Callable Bond – the issuer of the debt obligation retains he right to redeem the bond before its maturity date
                      • Putable Bond – the holder of the debt obligation (the borrower) retains the right to redeem the bond before its maturity date
                      • Convertibility
                        • Convertible debt securities allow the debt security holder to convert the debt obligation into common equity

 

Elements of Fixed Income Analysis

The following elements are typically common when analyzing the fixed-income security of a corporation

  • Credit Analysis
    • Analysis of the company’s financial statements
    • Assessment of creditworthiness and capacity to pay
    • Analysis of collateral and covenants
    • Risk Analysis
      • Corporate fixed-income securities are exposed to certain risks, which can include one or more of the following
        • Interest rate risk
        • Inflation risk
        • Credit or default risk
        • Liquidity risk
        • Foreign Exchange risk
        • Sovereign risk
        • Fixed-Income Valuation
          • A time-value based formula and methodology is used to value fixed income securities
          • The bond’s interest payments and principal are discounted back to today, to arrive at a present value figure (which is the bond’s value)
            • The present value of each future cash flow is found and summed up
  •  The following are needed to perform the valuation
    • The coupon or interest rate
    • The coupon or interest payments
    • The Face Value or Principal amount
    • The discount rate used to find the present value of each future cash flow
    • Comparison with Government Debt Securities
      • Fixed-income analysis also includes a comparison of the corporate debt-security’s return or yield with that of risk-free US government debts (Treasuries)
        • These are highly safe, liquid, and debt obligations
        • The return on Treasuries is seen by investors as the minimum acceptable or possible return in the market
        • The return on corporate fixed income securities is compared to the return on US treasuries to measure the “extra” yield/return offered (also referred to as risk premium)
          • This extra return is required by investors for assuming the risks inherent in corporate fixed income securities (see above for list of risks)

 

Conclusion

Fixed income analysis is the analytical framework used to evaluate and assess fixed income securities for investment purposes. This includes credit and risk analysis, as well as bond valuation. It applies to securities such as government and corporate bonds, and plays an important role in the trading and pricing of such instruments in the market.

 

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