Fixed Income Analysis – Assessing Value and Risk in Bonds

Fixed income analysis involves evaluating the value and risk of debt securities.

These analyses play a role in deciding whether to buy, sell (short sell), hold, hedge, or avoid a particular security.

Fixed income products, which primarily consist of bonds, are issued by various entities, including government treasuries, government agencies, companies, and international organizations.

This article looks into the process of valuing fixed income securities and the key factors considered in fixed income analysis.

 


Key Takeaways – Fixed Income Analysis

  • Fixed income analysis involves evaluating the value and risk of debt securities (mostly bonds) to inform investment decisions.
  • Key factors in fixed income analysis include yield premium, overlooked/broadly unknown risks, inflation and inflation expectations, real interest rates, business and economic cycles, interest rate changes, and fiscal and monetary policy.
  • Three main approaches to fixed income analysis are fundamental analysis, technical analysis, and relative value analysis, providing a mix of approaches in how to evaluate of fixed income investments.

 

Calculating Value

The value of a fixed income security can be determined by estimating its expected cash flows and the required yield.

The cash flows include periodic interest (coupon) payments before the maturity date and the repayment of the principal at par value upon maturity.

The required yield is established by comparing yields on securities with similar risk profiles in the market.

Applying the required yield to the expected cash flows estimates their present value. The present value is simply the security’s value.

Analysis

Fixed income analysis involves several key factors, including:

Yield premium

Analysts must assess the appropriate yield premium for the security compared to a US Treasury security of the same maturity.

The yield premium should account for the risks associated with:

  • the type of issuer
  • creditworthiness
  • embedded options (such as call features)
  • term structure of interest rates (yield curve)
  • taxability of interest, and
  • expected liquidity of the security

Overlooked or hidden risks

The analysis should identify any new or hidden risks that the market may have overlooked and estimate their potential impact.

For example, oil companies are subject to government policies that are heavily out of their control, such as approval over drilling, pipelines, climate policies, and so on.

Inflation expectations

Analysts should consider whether inflation is expected to improve or worsen and how that might affect the security’s value.

Generally speaking, rising inflation expectations are bad for fixed-income securities because market participants demand more compensation to offset this rise, causing the values of existing securities to fall.

Real interest rate

The real interest rate built into the yield should be examined to determine whether it aligns with the expected GDP growth rate (for treasury/government bonds) or earnings growth rate (for corporate bonds).

Business and economic cycles

The analysis must take into account the company’s position in its business cycle and the country’s position in its economic cycle.

Safe government bonds generally have their highest demand when the economy is weak (interest rates are low and people want to hide in safe assets) while they have their lowest demand when the economy is hot and there is greater demand for other securities like stocks.

Interest rate changes

Any expected changes in the basic real interest rate in the near future should be considered, along with the potential for monetary easing or tightening due to prevailing economic conditions.

Fiscal and Monetary Policy & Financial authorities’ responsiveness

The analysis should evaluate the nature of fiscal and monetary policy and how proactive or reactive the financial authorities in the country are in responding to inflation and economic conditions.

Approaches to Fixed Income Analysis

Three main approaches are used for analyzing fixed income products:

  • the fundamental approach, which examines the issuer’s financial health and the macroeconomic environment
  • the technical approach, which focuses on historical price patterns and trends; and
  • the relative value approach, which compares the security’s valuation with other securities with similar risk profiles.

We’ll briefly talk about each:

Fundamental Approach

This method involves analyzing the financial health of the issuer, including their earnings, balance sheet, cash flow, and other financial metrics.

Analysts also consider the wider macroeconomic environment, such as interest rates, inflation, and economic growth, which can affect the issuer’s ability to make timely interest and principal payments.

The fundamental approach helps determine the creditworthiness of the issuer and the underlying risk of default.

Global macro hedge funds will generally be more concerned about the broader macroeconomic picture.

Credit-focused funds will typically be more interested in company-/issuer-specific analysis.

Technical Approach

This approach primarily focuses on price patterns and trends of the fixed income security.

It uses various charting techniques, statistical measures, and mathematical models to predict future price movements.

The technical approach assumes that all available information is already incorporated into the security’s price, and therefore, the historical price trends can be used to predict future movements.

This might also include matters like flows and positioning. We covered how bonds (and other asset classes) are impacted by flows and positioning in this article.

Relative Value Approach

The relative value approach/method involves comparing the security’s valuation with other similar securities to determine if it’s over or underpriced.

For example, two bonds from similar issuers with comparable credit ratings, maturities, and coupon rates should theoretically have similar yields.

If there’s a significant difference in yields, it may suggest that one bond is overvalued or undervalued relative to the other.

The trader may then choose to buy the undervalued one (as it’s perceived) and short the overvalued one.

One benefit to the relative value approach is that it can avoid having correlation to the broader market due to offsetting longs and shorts.

This is beneficial for funds that are looking to be uncorrelated to broader market movements and create alpha.

This approach is often used in conjunction with the other two methods to provide a more comprehensive analysis of the fixed income security.

 

FAQs – Fixed Income Analysis

What is fixed income analysis and why is it important?

Fixed income analysis is the process of evaluating the value and risk of debt securities, primarily bonds, to help traders/investors make informed decisions about buying, selling/shorting, holding, hedging, or simply avoiding these securities.

It’s important because it provides insights into the expected cash flows, risks, and prospective returns associated with fixed-income securities.

What are the main components of calculating the value of a fixed income security?

The value of a fixed income security is calculated by estimating the expected cash flows (periodic interest payments and principal repayment at maturity) and determining the appropriate required yield by comparing yields on securities with similar risk profiles.

Applying the required yield to the expected cash flows estimates their present value, which equals the security’s value.

What factors are considered in fixed income analysis?

Key factors considered in fixed income analysis include:

  • the yield premium
  • overlooked or hidden risks
  • inflation expectations
  • real interest rate
  • the company’s position in its business cycle (or the country’s position in its economic cycle)
  • expected interest rate changes
  • fiscal and monetary policy, and
  • the overall responsiveness of financial authorities to inflation and broader economic conditions

How does the yield premium factor into fixed income analysis?

The yield premium is the additional yield an investor demands for holding a security with higher risk compared to a lower-risk US Treasury security with the same maturity (or whatever the “risk-free” reference security is).

The yield premium should account for various factors, such as the type of issuer, its creditworthiness, any embedded options, the term structure of interest rates, taxes, and the liquidity of the security.

What approaches are used for analyzing fixed income products?

There are three main approaches to fixed income analysis: the fundamental approach, which looks at the company/country/issuer’s financial health and the macro environment; the technical approach, which looks at historical price patterns and trends; and the relative value approach, which compares the security’s valuation with other securities with comparable risk profiles.

How do inflation expectations impact fixed income analysis?

Inflation expectations matter in fixed income analysis because they can affect the real value of the interest payments and principal repayment.

For example, if a bond pays 2% interest but the inflation rate is 5%, the real yield is minus-3%. So, if a bond is being issued at just a 2% coupon, that will impact its demand in such an environment.

It would likely sell off so that its yield compensates for inflation and its risk profile.

Generally speaking, if inflation is expected to worsen, it may erode the real value of the bond’s cash flows, while improving inflation expectations can enhance the real value.

Analysts must consider these expectations when determining the required yield and assessing the security’s overall value.

How do real interest rates factor into fixed income analysis?

The real interest rate is the nominal interest rate adjusted for inflation.

It’s an essential factor in fixed income analysis because it can provide insights into the attractiveness of a bond compared to other investments or alternative bonds.

A higher real interest rate may indicate a more attractive investment, while a lower real interest rate may signal lower returns or simply increased risks in buying it at that price.

 

Conclusion

Fixed income analysis is an important process for determining the value and risk of debt securities, helping traders/investors/market participants make informed decisions about their portfolios.

By examining various factors, such as yield premium, risks that aren’t well-known to the market, inflation expectations, and real interest rates, analysts can provide insights into the potential performance of fixed income securities.

Employing a combination of fundamental, technical, and relative value approaches ensures a comprehensive analysis that considers all relevant factors and potential angles and strategic/tactical approaches.

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