Fixed income analysis

Fixed income analysis is analysing fixed income products to find out if they are fairly valued, or not. The conclusion can be to buy or sell or hold or stay out of the particular product.

Fixed income products are generally bonds issued by various Governments, Treasuries, Companies and Organisations. Bond holders are usually entitled to get coupon payments at periodic intervals until maturity. These coupon payments are mostly fixed amounts or a percentage of the invested amount.

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 various time intervals in the future, one has to apply "Time Value of Money" and find out the "Present Value" of each cash flow. The sum of all the present value of Cash inflows occurring for the bond is technically the value of the bond.

To arrive at the present value, one has to apply appropriate discount rate. The appropriate discount rate typically is the sum

"Expected Real Interest Rate"+"Expected Inflation Rate"+"Risk Premium".

Expected Real Interest Rate is generally equal to the base (inflation-adjusted) rate offered by a bank on its 3 months deposits. This may keep varying several times in a bond's life time. Expected Inflation Rate is what rate of inflation you generally expect at various periods into the future. Risk premium is the arbitrary rate the investor adds as his opportunity cost by investing in the particular security.

To analyse fixed income product, one has to analyse these discount rates applied. To find out the discount rates applied over the spectrum of the period on any bond valuation is very very difficult if not impossible. So, the market has come up with a term "Yield" which is the rate collectively represents all the discount rates applied in the bond price calculation. This can be found by using standard IRR formula.

Yield is the rate of income what an investor will get if he holds the bond till its maturity. And Yield can be broken into its 3 main components = Real rate + Inflation rate + Risk Premium. And when you do such breaking, now you are in a position to compare one bond with another.

For example when you see the market is pricing US 10year Treasury bond at 4.50% yield, and you know the current FED RATE for 3m deposit is 2.00% and the inflation expectation is 2%, you conclude that market is placing 0.50% premium for the risk it takes to invest in US 10year Treasury bond. If you keep this as a benchmark, you can compare a bond issued by any other entity like Govt of Argentina or a company like Microsoft.

If you ask 4.50% from AAA rated US Treasury, you may want to add another 0.50% for another AAA rated giant organisation or additional 5% for CCC rated junk bond. These are only examples. We call the additional rate over and above the US Treasury rate as Spread. And these spreads are subjected to market forces like stock prices.

Following are the typical questions an analyst finds answers for:

Is the real interest rate built into the yield makes 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?
Is there any change expected in the basic real interest rate in the near future?
Do the prevailing situations of monetary and economic conditions force any monetary easing or tightening conditions so that the base real rate will get changed?
Is the inflation condition worsening or improving?
Are the financial authorities in the country are 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?
What is nature and volume of supply for a particular bond?

The demand for fixed income products come from banks, insurance companies, pension fund companies, endowment organisations, External Government Treasuries, individual investors like retirees and widows 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 those were 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 anaysing fixed income products are broadly as follows: Fundamental approach; Technical Approach; Relative Value Approach