Help Me Understand Fixed Income Investing

Can someone please help me understand fixed income investing? Lets take treasury bonds for example. Say I invest today do I want yields to decline so the price appreciates? Or do I want yields to increase? Also, are the rates floating in the sense that if I invest in a 10-yr t bond and yields decline dramatically do I get paid that new yield or the yield that I originally invested in? Also can you sell the bond prior to maturity and would there be any implications to this? I apologize for the rookie questions just trying to understand

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Comments (24)

Aug 13, 2020 - 11:26am

Completely depends on the strategy of the investor. FI is such a big space that you can't really make broad generalizations like that. I will say that for the FI asset management space as a whole, low yields for a long time period are a bad thing. Managers have to reach for yield, inherently getting more risk-on or losing out to competitors who will. In the next decade with rates where they are, it'll probably be the biggest firms that survive as they compress fees, and smaller more nimble firms with specific strategies. The days of a mid-sized AM firm specializing in FI are over and these firms will get squeezed.

Aug 13, 2020 - 11:39am

Sounds to me like you are confusing the coupon payments with the yield. Yield moves inversely to price. If you already own the instrument and yields have fallen, it means your asset has appreciated and you can now sell it for more than you bought it for.

As another comment said, usually fixed income managers are focusing on managing the curve and targeting a certain yield/risk. As yields fall this can force them into riskier instruments.

  • Prospect in Other
Aug 13, 2020 - 4:21pm

I think I am confusing the coupon payments and the yield. Could you explain to me the difference? I was assuming the yield is what you would get paid every year for purchasing the bond but it sounds like you're saying thats the coupon

Aug 13, 2020 - 4:57pm

For simplicity sake (ignoring floaters and other complications) the coupon rate is fixed at the issue of the bond and is usually paid out semi annually. Versus the yield, which is a measure of return on investment (yield to maturity, although there are other ways of measuring yield). The price of the bond can go up or down, which will affect the yield of the bond, but the amount of money you earn from the coupon (coupon rate) remains fixed.

Super basic example: you buy a bond for $100 which has face value $100 and pays $2 coupons. Your coupon rate and yield here are both 2%. However, if the price of the bond falls to $90, and you're still getting the $2 coupon (2% coupon based on face value), the yield has risen to 2.22% ($2 / $90). Yield moves inversely to price. Note that this example excludes many many complications of bond maths and is simply to try and highlight the difference between coupon payments and yield.

Most Helpful
Aug 13, 2020 - 12:14pm

As basic as possible - using treasury bonds as an example. Simplified and generalized for example purposes.

  • I issue a bond, today, at par value. 100 is par. It has a yield of 2% which gives me a 'coupon' (the fixed cash flow i'm getting off the bond). In this case - I'm getting 2 dollars a year, no matter what, in cash flows off that bond. Let's say it's for 10 years.

  • Assuming that it's a plain, normal bond, I get those cash flows, 2 dollars a year, for 10 years. That doesn't change no matter what (unless, of course, Jerome Powell forgets his checkbook one day).

  • When rates change, let's say they fall, and a similar treasury is now at 1.5%. The price of my bond will rise - the coupon doesn't change, i'm getting 2 dollars every year still + I have a gain in my bond's value (that 2 dollars is worth more now as yields have fallen). If it's been a year - i can sell that bond, realize the 2 dollars in coupon payments + the change in price due to rates moving. That's called 'total return' - what most active managers look to achieve in the fixed income world.

  • There are bonds that have floating rates - called floaters - where generally you will have a reference rate plus a spread (i.e. in a former world, it would be something like LIBOR + 1.5% or whatever). You'll know by looking at the bond docs or whatever.

  • Now, the question of do I want this? It depends on the investor. Some investors, like Insurance companies, really only care about the yield of the bond when they buy it - as they plan to hold it to maturity, and want to lock in the return target they need (i.e. they need 5% a year - 2% get's them part of the way there, every year). It's going to vary widely across strategies, client preferences, needs, risk tolerance, etc.

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  • Prospect in Other
Aug 13, 2020 - 4:19pm

Thanks a lot for the answer this was a really good explanation. So to your last point, if I hold the bond into maturity, do I get my initial investment back or do I get whatever price the bond is trading at at that time?

Aug 13, 2020 - 4:25pm

You will only ever get par back at maturity. Only time you will get back a different price is if it is called or in default

Array

Aug 13, 2020 - 3:44pm

If your priority is returns then you want yields to go down (if you already own the asset). Yields are a substitute for price in fixed income, except their relationship to the quality of the asset is inverse to price, so yield go up, price go down.

Yield at the time of acquisition is a snapshot of the return you will get if you buy and hold the bond to maturity.

Keep in mind that all the price of a bond is in most cases is the present value of the cash flows (coupons + maturity). Yield is the magic % that is your discount factor to get the present value of all your cashflows to equal the price.

Σ (big sigma/sum) [cash flow for t / (1 + YIELD) ^ t] for all periods t to T (the # of periods to maturity) = price

Where every CF at t that isn't T is just coupon rate times par and CF at T is coupon rate * par plus par

In the case of standard fixed coupon bond, the relationship between the coupon rate and the yield is as follows.

If coupon = yield, price = par

If coupon > yield, price > par

If coupon

Aug 14, 2020 - 9:44am

I'll add to this why fixed income instrument prices move inversely with yields:

  • A bond typically has set coupon payments and return at maturity (par). Every quarter you receive $X and at the last payment you receive the original face amount of the bond.

  • However, investor demand (i.e. the yield or expected IRR we're willing to accept in any period when we enter an investment) continues to move up and down.

  • If the coupon payments (future cash flow stream) is not moving, then the only thing that can move to reflect demand is the price investors are willing to buy/sell at.

  • If a $100 bond was issued at par at a 6% coupon. Every period you'll only get that $6 and an ultimate repayment at maturity of $100. But if yields are now 5% but that coupon stream is still $6, then the only way to get that overall yield down is to pay more for the same bond.

  • Prospect in Other
Aug 14, 2020 - 11:25am

Thanks guys for all of the answers they were all helpful.

I've been hearing recently that treasury yields reflect where the market believes the Fed will set rates in the future. Does this mean that if the 30 yr is at 1.5% the market believes that interest rates will be 1.5% in the future (and so on at every tenor i.e. 10-yr at 0.7% so does this mean the markt believes rates will be .7% in the future?). Does the yield on treasuries signal anything about inflation?

Aug 14, 2020 - 11:50am

this is where you will get tons of different opinions. my take on this is unless someone has a good track record of predicting this stuff, it's all just intellectual masturbation. I also remember one time when I saw Abby Joseph Cohen speak at Goldman, they pointed out that the fed funds futures curve is always wrong, they call it a "hair chart" and it basically shows that it's really frikkin hard to predict this stuff accurately and over long periods of time.

what's also important is your return considering the risk you're taking (I'd argue some BB credits only paying 4% doesn't compensate you for the inherent risk, you'd be better off with a dividend paying stock). one aspect of fixed income investing that most people don't talk about is how those yields affect other asset classes. you may have heard the phrase "pushed out on the risk curve" and basically this is an observation of would-be fixed income investors buying equities and real estate because bonds do not meet their required rate of return. if your required return is 7% and stocks give you 10%, in the past you could do 50/50 stocks and bonds because bonds yielded 4%+ (high quality bonds, not just high yield) now. in order to meet your required rate of return, you have to go out in maturity, down in credit, or to another asset class to meet that return objective. in today's world, that would likely mean 70% of your money in stocks (using my inputs) which exposes you to more potential downside. I say all of that because fixed income investing is usually applied in my world as a filler for the non-risky parts of portfolios. however, if an investor's required rate of return hasn't adjusted to interest rates, this means we need to change how we allocate to bonds.

finally, a word on liquidity. this is an often forgotten part of the bond market. sure, when we're talking AAA munis/corps plus treasuries, liquidity isn't an issue, but high yield, some floating rate, etc., are risky plays. you may not be able to get out of the bond you purchased because it's not like a stock where there are constantly bids out there. because every bond is unique whereas every share of AAPL is identical, it can make for liquidity issues. this is not an issue if you don't experience default and your intent is to hold to maturity, but most people don't hold bonds to maturity so liquidity is paramount, and if your bond isn't liquid, you should demand a higher yield to compensate you for that.

Aug 18, 2020 - 9:49am

Piggybacking off of thebrofessor here - the yield curve, and fixed income market, has been so disconnected from 'traditional' economic thoughts it's almost a joke.

An example of this is the adage that inflation shows up on the long end of the curve. Traditionally, yes, it should. But realistically there are a ton of technical issues that make that relationship, at best, tenuous. When rates tick up on the long end - yield starved institutional will gobble it up. 3.5% yield. Consider pension funds, insurance companies, etc. who have yield mandates and long term liabilities they have to pay out - if I can lock in half the return I need? Thank you. Oh, and It doesn't count against risk budgets? Oh yeah! Sign me up! Thus - it logically will help keep a lid on yields for the time being, and even if you saw inflation it would get dampened pretty quickly.

Also - and i'm digressing, but, whatever - liquidity in the bond markets is a total nightmare nowadays. Across the curve. When everything hit the fan in March/April - IG spreads across the board were awful, when you got down to the issuer level it was even worse. Hell - even on the run vs. off the run treasuries were all over the place. it's wild. Fixed income is wild.

Aug 15, 2020 - 9:17am
thebrofessor:

Most of the technical stuff I've learned on fixed income is from the CFA curriculum and undergraduate capital markets classes

For books, most people don't know this but a lot of Graham's security analysis is on fixed income, maybe 20% is on equity. That, and one or two fabozzi books should get you up to speed

Interesting to note that although most looking at "the market" think equities, the debt / credit market is massive (several times the size of the equity market) and, I think, more complex. Having a great understanding of it is key if you want to work with institutional money (and even HNW/UHNW).

Aug 17, 2020 - 8:41am

It's always freaking Fabozzi - I think this might be standard issue in every fixed income manager's office. They really should consider doing a coffee table version.

To the OP - the free investopedia sections for CFA level 1 honestly are a great place to start (i assume they still exist). Mark Meldrum use to have some free youtube videios, also for level 1, on the fixed income section. All are worth looking at.

Also - historically, whenever I don't know something I literally google 'XYZ Primer' and, more often than not, I get some pretty good results. I'd try that as well for fixed income. My view is that you should focus on understanding bond mechanics but, importantly, get a really good sense for the market structure and how the actual markets work. Once you get a decent handle on this stuff - start digging into primers on ABS (basically, securitized/structured credit stuff) as those dominate large portions of the fixed income market and influence a lot more than you'd realize.

One place I would have you focus on is the bond market structure and mechanics. I personally think that this is fascinating, especially as you start to consider the Fed's role in the day to day growing exponentially larger (i'll with hold judgement for the moment on this) with all their various facilities they use to intervene. The implications of their repo operations can take up papers unto themselves - before you get to the impact on credit markets, both IG and High Yield.

Anyway - all that should get you started.

Aug 14, 2020 - 11:48pm

Hull's Options book will give you a strong foundation for fixed income and derivatives (some of the stuff will be over-kill, but if you can understand everything in that book you will be extremely well off in the field).

The CFA curriculum has a fixed income portion, and the curriculum lists its references (many of the references come from Fabozzi's and Hull's works).

With some googling, you can find everything for free online.

Array
Aug 16, 2020 - 4:59pm

Your questions are fine to ask - there are some concepts you're confused about, which are driving many of the questions. To keep things really, really simple:

  • Yield vs price: here's what you need to understand: they're different ways of referring to the same thing.

  • First, recall the concept of the coupon rate. A bond issued at $100 with a 2% annual coupon rate is paying a $2.00 a year.

  • Does this mean the issuer is paying 2% interest? Well, if the bond's price is $100. Then yes. Work it out if the bond's current price is $99, and if the bond's current price is $101. (Hint: take the cash outflow, divide by the price, and you'll get the interest rate).

  • Similarly, does this mean the bond is yielding 2%? Consider the above scenario yet again. The semantic differences (eye of the beholder) between yield and interest are, well, interesting if you have a lot of time, which we don't.

  • Based on the above, if a bond's yield has gone UP, what can we infer about the bond's price? Similarly, if a bond's yield has gone DOWN, what can we then infer about the price?

  • In summary, then, realize that yield and price are describing the same thing, in different words, observed from a different point of view. *If you know the value for one (either price or yield), and you know the bond's maturity, payment frequency, coupon rate, and face value, then you can back out the other. *

Right, so your next questions are about what happens to a bondholder as a bond's yield moves, or selling the bond prior to maturity. Remember:

  • As a bondholder, you are receiving the same cash coupons on the given payment date. Errr, "fixed" income, err.

  • What changes, for you, is the % these coupons represent of the bond's present value. You're holding the bond in your books, and you're booking a fixed amount of cash as well.

  • "The bond's value" is not a mystical concept. This is a fixed income asset. It spits out cash according to a schedule that is already known to you, in amounts that are already known to you. The bond's price should be its net present value. The bond's yield is the value that gives today's price, based on the remaining payments the bondholder is entitled to.

  • If you decide to sell the bond at the market price, you will receive cash equivalent to the bond's price, and you will no longer hold the bond, or be entitled to any of the coupons and repayment afforded to the bondholder. You gave that up, for a price - the bond price. The bond price reflects all that information.

  • In reality, there is a bid/ask spread around the bond's price.

Hope that helps. You'd be surprised how many bankers involved in large debt deals don't actually know the basics around fixed income math, economics and accounting.

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