Fixed Income

Abstract

In prior chapters, our analysis focused primarily on equity securities as examples. However, based on size, the US stock market is actually smaller than the US fixed income market. In 2012, the US bond market stood at $ 37 trillion, while the US equity market stood at $ 21 trillion. 1 In this chapter, our analysis focuses on fixed income securities as examples. Many of the techniques used in this chapter are also equally applicable to both equity and fixed income securities. We begin our analysis of fixed income securities by showing how to obtain and analyze economic data. Many investments have a relationship with macroeconomic variables, which makes analyzing economic data important to understanding how our investments may perform during our holing period. We then demonstrate an analysis of Treasury yields. Since other fixed income instruments rely on the rates of Treasury securities, understanding the shape of the yield curve and the slope of the yield curve is essential to making sound fixed income investment decisions. We also show how to look at the real yield of Treasury securities and observe the decline in real yields in recent years. Then, we demonstrate how to identify mean reverting patterns in Treasury securities. Next, we analyze the time series of spreads between corporates of different investment grade ratings. We show how such an analysis can reveal the widening or tightening of credit spreads. The second part of this chapter demonstrates discounted cash flow bond valuation. First, we look at the simple case of valuing a bond on a coupon payment date. We implement the calculation in two ways, with the first laying out every step and the second by showing how to create a function so we can repeatedly calculate bond prices with relative ease. Second, we implement a bond valuation calculation on non-coupon payment dates. The main difference in this latter approach is we need to add accrued interest. We also demonstrate how to calculate duration and convexity of bonds, which are tools used to manage interest rate risk. 1