Fixed Income Trading

Trading Bonds and other Debt Instruments

What is fixed income trading?

Fixed income trading is the process of trading fixed income securities over-the-counter (OTC).  The fixed income market has low transaction costs, a competitive market structure, and heterogeneous market participants. The fixed income securities market is dominated by institutional investors.

 

What is a fixed income security?

A fixed income security or a debt security is a claim on a particular periodic income stream. Fixed income securities are named so because they guarantee a stream of income that is determined by a formula or a fixed stream of income.

Types of instruments traded in the fixed income market

The following table lists the different instruments traded in the fixed income market:

 

Factors affecting trading in the fixed income market

The following factors affect fixed income trading:

  • Credit/Default  risk: Credit/default risk arises if the issuer of a security is unable to

    • Pay interest and/or principal in a timely fashion

    • Comply with the provisions of a bond indenture

  • The probability of credit/default risk occurring depends on the issuer’s ability to meet their financial obligations and their credit worthiness. There is a negative correlation between credit rating and yield- lower the credit rating, the higher the yield (to compensate for higher credit risk) and vise-versa. A change in the issuer’s credit rating affects the value of their outstanding fixed income securities.
  • Interest rate risk: There is negative correlation between the price of debt securities and interest rates. However, there is a positive relationship between interest rate and yield. Interest rate risk arises when an adverse change in interest rate has a similar adverse impact on the yield of debt securities.

  • Reinvestment rate risk: This refers to the probability of a decline in the interest rate causing a decline in the options available for investing the interest income received at higher or similar rates in the market.

  • Counter-party risk: The inability of the opposite party to the contract to deliver the sale value or the promised security at the time of settlement results in counter-part risk.

  • Price risk: Price risk results when, due to an adverse movement in prices, the investor does not receive the expected price. This is particularly relevant to investors who want to access principal amount invest before the maturity of the security, as they have to rely on the prevailing market price of the security which may be higher or lower than the paid price of the security.

  • Purchasing Power Risk : While investing fixed income investors look at the real rate of return i.e.

  • Real rate of return = Actual return – Rate of inflation
  • Inflation, however, reduces the purchasing power of the principal invested and the investment income. Thus, inflation has an inverse relationship with real rate of return: the higher the inflation, the lower the real rate of return (and vise-versa).

Suitability of investment

To achieve different goals, an investor can invest in different types of fixed income securities:

  1. Capital appreciation: Those aiming to make capital gains should primarily invest in low rated securities like emerging market debt or high yield-bonds. If interest rates are likely to fall, investing in government bonds and long term maturity corporate bonds also results in capital gains.

  2. Income: All fixed income securities (barring zero-coupon bonds) provide some form of income for the investors. However, if the investor is not particularly risk averse, they can invest in mortgage backed securities and/or corporate bonds if earing an income is their primary goal.

  3. Safety: Risk averse investors seeking safety investments should invest in securities with short maturity periods (less than 5 years) to reduce interest rate risk and in securities with a high credit rating to avoid default risk. Some debt securities which meet the aforementioned criteria are: U.S. T-bills, money market instruments (especially certificate of deposits), short-term corporate debt, and municipal bonds having a high credit rating.

  4. Tax advantages – Those seeking to maximize their after tax-income should invest in municipal bonds as they are tax-free (most of the time).

 

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