Fixed Income Investments
Bond Fundamentals
Fixed income analysis begins with price–yield relationships: bond prices move inversely to yields, and longer maturity and lower coupon bonds have greater price sensitivity (duration). Master the distinction between coupon rate, current yield, and yield to maturity (YTM), and understand that YTM assumes reinvestment of coupons at the same rate.
Duration and Convexity
Macaulay duration is the weighted average time to cash flows; modified duration measures percentage price change per unit yield change: %ΔP ≈ −D_mod × Δy. Convexity refines the estimate for larger yield moves and is positive for plain vanilla bonds, meaning gains exceed losses for symmetric yield changes. Zero-coupon bonds have duration equal to maturity.
Credit and Structure
Understand credit ratings, credit spreads, and the drivers of spread (default risk, liquidity, tax). Know callable, putable, convertible, and floating-rate features and their yield implications: callability raises yield (bad for investor), putability lowers it (good for investor).
Common Traps
- Assuming a premium bond's current yield equals its YTM (it does not).
- Forgetting that duration underestimates price change for large yield moves without convexity adjustment.
- Confusing reinvestment risk (higher for high-coupon, long-horizon) with price risk.
Worked Example
A bond has modified duration 6 and convexity 50. Yields rise by 1% (0.01). Duration effect: −6 × 0.01 = −6%. Convexity adjustment: 0.5 × 50 × (0.01)² = +0.25%. Estimated price change ≈ −5.75%.