Fixed Income Markets: Analysis and Valuation
Global Fixed Income Market Classifications
Fixed income markets are categorized to help investors navigate different risk and return profiles. Common classifications include:
- Type of issuer: Government, corporate, or municipal.
- Credit quality: Investment grade vs. high-yield.
- Maturity: Short-term, intermediate, or long-term.
- Currency: Local vs. foreign currency.
- Type of coupon: Fixed-rate, floating-rate, or zero-coupon.
- Geography: Developed vs. emerging markets.
- Tax status: Taxable vs. tax-exempt bonds.
Primary and Secondary Bond Markets
Primary Market
The primary market is where issuers sell new bonds to raise capital. Issues may occur through public offerings or private placements. In a public offering, investment banks assist the issuer. In an underwritten (firm commitment) issue, the underwriter purchases the entire issue and resells it, assuming price risk and earning an underwriting spread. In a best efforts issue, the bank acts only as an agent for a commission. Sovereign bonds are frequently issued via auctions using competitive and non-competitive bids. Private placements are non-public, typically unregistered issues sold directly to institutional investors; they are less liquid but often offer higher yields.
Secondary Market
The secondary market is the “aftermarket” where existing bonds trade among investors. The structure may involve organized exchanges or over-the-counter (OTC) markets. OTC markets rely on electronic networks and dealer quotes. Liquidity refers to the ability to trade quickly at prices near fair value; the bid–ask spread is a primary indicator (a narrow spread signifies high liquidity). Government and quasi-government bonds generally settle on a T+1 basis, while corporate bonds typically settle T+2.
Sovereign Bonds and Government Debt
Sovereign bonds are issued by national governments to finance budget deficits. Notable examples include US Treasuries, JGBs, Gilts, and Bunds. In the US, T-bills have maturities up to 1 year, T-notes range from 1 to 10 years, and T-bonds exceed 10 years. The most recently issued bonds of a specific maturity are called on-the-run or benchmark issues and are the most actively traded.
Sovereign bonds are unsecured but backed by the government’s taxing power. High-rated local-currency sovereigns are considered nearly free of credit risk. Ratings often differ between local-currency and foreign-currency issues because governments can print local currency but must acquire foreign currency. Types include fixed-rate bonds, floating-rate bonds (linked to a reference rate), and inflation-linked bonds, where the principal or coupon is adjusted for inflation.
Corporate Debt and Short-Term Funding
Companies raise debt for working capital and long-term investments. Bank loans may be bilateral (one lender) or syndicated (a group of lenders), usually at floating rates linked to LIBOR, Treasury rates, or the prime rate. Commercial paper is a short-term, unsecured promissory note (overnight to 1 year) used for bridge financing. It involves rollover risk, requiring issuers to maintain backup lines of credit. Yields are higher than sovereign bonds due to credit risk and lower liquidity.
Medium-term notes (MTNs) are offered continuously and can be highly customized. Principal repayment may follow a serial structure (installments) or a term structure (lump sum), often utilizing a sinking fund to mitigate credit risk. Debt may be secured (with collateral) or unsecured and may include contingency provisions like call, put, and conversion options.
Money Market Instruments
Money market instruments are short-term debt tools with high liquidity and low credit risk. Major instruments include:
- Treasury Bills: Discounted government securities with maturities up to one year.
- Commercial Paper: Unsecured corporate notes, typically maturing in less than 3 months.
- Certificates of Deposit (CDs): Negotiable time deposits issued by banks.
- Repurchase Agreements (Repos): Short-term collateralized borrowing.
- Bankers’ Acceptances: Bank-guaranteed instruments used in international trade.
- Call and Notice Money: Interbank funds; call money is overnight, notice money is 2 to 14 days.
Securitization and Structured Products
Securitization is the process of pooling illiquid assets, such as loans, and converting them into marketable securities. The originator sells assets to a Special Purpose Vehicle (SPV), which issues securities backed by the asset cash flows. This process improves liquidity and transfers credit risk.
Securitization in India
In India, this process is governed by the SARFAESI Act (2002) and regulated by the RBI. Common securitized assets include housing, auto, microfinance, and gold loans. Banks and NBFCs use this to free up capital and improve liquidity.
Mortgage-Backed Securities
- Residential Mortgage-Backed Securities (RMBS): Backed by home loans; payments depend on homeowner EMI payments and are subject to prepayment risk.
- Commercial Mortgage-Backed Securities (CMBS): Backed by commercial real estate (malls, offices). Cash flows come from rental income. These offer higher yields but carry higher credit risk than RMBS.
Asset-Backed Securities and CDOs
Non-mortgage ABS are backed by auto loans, credit cards, or student loans. Collateralized Debt Obligations (CDOs) are structured securities backed by a pool of bonds or loans. The SPV divides the CDO into tranches (Senior, Mezzanine, and Equity) to redistribute credit risk.
Sources of Return
- Coupon interest from underlying loans.
- Principal repayments and prepayments.
- Credit spread compensation.
- Reinvestment income on interim cash flows.
Valuation of Fixed Income Securities
The value of a bond is the present value of all future cash flows discounted at the required yield. Bond prices and yields move inversely. Longer-maturity bonds are more sensitive to interest rate changes, while higher-coupon bonds are less sensitive. Callable bonds typically have lower prices than non-callable bonds because the issuer may redeem them early, whereas putable bonds command higher prices.
Credit Risk and High-Yield Analysis
High-yield (non-investment grade) bonds require deep analysis of cash flow stability and liquidity buffers. Analysts focus on covenant protection and recovery analysis, estimating asset values in the event of liquidation. Credit risk includes default risk, downgrade risk, credit spread risk, and recovery risk.
Credit Ratings and Agencies
Agencies like Moody’s, Standard & Poor’s, and Fitch assign ratings from Investment Grade (AAA to BBB) to Non-Investment Grade (BB and below). Ratings influence borrowing costs and investor demand but are opinions rather than guarantees.
Interest Rates and Monetary Policy
Interest rates determine the discount rate for bond valuation. The Repo Rate is the rate at which the central bank lends to commercial banks; raising it reduces liquidity and increases bond yields. The Reverse Repo Rate is the rate at which the central bank borrows from banks to absorb excess liquidity. Together, they form a monetary policy corridor that influences the entire financial system.
Corporate Credit Ratios
Analysts evaluate creditworthiness using key ratios:
- Interest Coverage Ratio: EBIT or EBITDA / Interest Expense.
- Leverage: Debt-to-Equity and Debt-to-EBITDA.
- Liquidity: Current and Quick ratios.
- Sustainability: Cash flow from operations to total debt.