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Fixed income analysis using Yield Curve Construction

May 15, 2018

Fixed income products are bonds issued by companies, Government treasuries, or organizations. Bondholders are entitled to periodic coupon payments on these bonds until maturity. This coupon amount is fixed as a percentage of the bond’s face value or can float as well. Analyzing the trend that a particular bond shows with respect to the future, and as an investment, comprises of the fixed income analysis.

 

Fixed income analysis means the process of valuation of debt securities or fixed income securities along with an analysis of the risk associated with these securities. Fixed income analysis is generally done to help a person decide whether to sell, hold, buy, or hedge certain securities.

 

In this article, we will take a look at ways to perform a fixed income analysis by three methods –

  •        Yield curve construction
  •        Trading strategies
  •        Risk analysis

Fixed income analysis using Yield curve construction

https://www.investopedia.com/terms/y/yieldcurve.asp

A yield curve is a line that plots the interest rates of bonds having the same credit quality but different maturity dates, at a definite point in time. The shape of the yield curve determines any changes in the economic activity or interest rates at a time in the future. There are three shapes of a yield curve – flat, normal, inverted – which signify a particular type of economic activity.

Let’s take a look at how to do a fixed income analysis depending on the shape of a yield curve.

  1. Normal yield curve:  A normal yield curve shows an upward slope, which means that longer-term bonds will continue to give higher yields. This means that the economy will see periods of expansion.
  2. Inverted yield curve: Conversely, an inverted yield curve shows a downward slope that signifies a downward trend in yields on longer-term bonds. This also suggests a chance of economic recession.
  3. Flat yield curve: A flat yield curve generally shows when the economy is going through a change. For instance, if it is going from recession to expansion, an inverted yield curve will first become flat and then may become normal.

Fixed income analysis Yield curve

Fixed income analysis using Trading Strategies

Fixed income analysis using Risk analysis

https://www.investopedia.com/exam-guide/cfa-level-1/fixed-income-investments/yield-curve-risk.asp

When it comes to analyzing risks, a lot of factors come into play. These determine whether you will get the desired returns on your bonds or not. It is also used to decide whether to purchase/sell/hold a bond. The following are some risks that need to be analyzed –

  •        Interest rate risk
  •        Reinvestment risk
  •        Credit risk
  •        Liquidity risk
  •        Call and prepayment risk
  •        Yield curve risk
  •        Exchange rate risk
  •        Volatility risk
  •        Inflation risk
  •        Event risk
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