Concept
Fixed income analysis is the process of determining the value of a debt security based on an assessment of its risk profile, which can include interest rate risk, risk of the issuer failing to repay the debt, market supply and demand for the security, call provisions and macroeconomic considerations affecting its value in the future. It also addresses the likely price behavior in hedging portfolios. Based on such an analysis, a fixed income analyst tries to reach a conclusion as to whether to buy, sell, hold, hedge or avoid the particular security. Fixed income products are generally bonds: debt instruments requiring the issuer (i.e. the debtor or borrower) to repay the lender the amount borrowed (principal) plus interest over a specified period of time (coupon payments) until maturity. They are issued by government treasuries, government agencies, companies or international organizations. To determine the value of a fixed income security, the analyst must estimate the expected cash flows from the investment and the appropriate required yield. The cash flows consist of: periodic interest (known as coupon) payments prior to the maturity date, and the repayment of the principal at par value upon maturity. The required yield is determined by investigating the yield offered on securities of comparable risk in the market. The required yield is applied to the expected cash flows to estimate their present value, which equals the security's value. Key factors considered in fixed income analysis include the following: What is the appropriate yield premium for the security being analyzed compared to a U.S. Treasury security of the same maturity, and how does that compare to the yield premium reflected in the actual market price? Is the premium built into the yield enough to compensate for the risks? The factors that affect the yield premium include: the type of issuer, the issuer's perceived creditworthiness, the potential impact of any embedded options, such as a call feature, which permit either the bondholder or the issuer to alter the cash flows, the relationship between the market yield on bonds of the same credit quality but different maturities (known as the term structure of interest rates, or yield curve) the taxability of the interest received by investors, and the expected liquidity of the security.