Basic introduction to Fixed income trading

The following factors affect fixed-income trading:

Credit/default risk:

This type of risk is relative to credit/default risk and is defined as the possibility of the issuer to fulfill their financial obligations and, thereby, their credit worthiness. Credit rating and yield bear an inverse relationship meaning that as one increases the other decreases. When the credit rating of the issuer is low, the yield on the bond will be higher due to high credit risk and vice versa. Since fixed-income analysts are sensitive to changes in the credit rating of the issuer, a change in its credit rating impacts the outstanding fixed-income securities.

Interest rate risk:

The price of debt securities has an inverse relationship with interest rates. There is an inverse relationship between interest rate and demand. There is a direct relationship between interest rate and yield. Interest rate generally occurs when the yield of the debt securities is affected by a change in interest rates.

Reinvestment rate risk:

This is the possibility that resulting from a reduced interest rate, the amount of options in terms of reinvestment of the interest income earned at higher or at par with the current rates in the market.

Price risk:

In the case of adverse movements in the price levels, price risk arises whereby the investor does not obtain the required price while disposing of a bond or other debt security in the secondary market. This is quite essential for investors who wish to get back the principal amount before the due date for the maturity of the securities because they cannot get back the actual price for which they have bought securities. Instead, they get the value depending upon the current market value, which may be cheaper or dearer in a way.

Purchasing power risk:

Fixed-income sectors focus on the real rate of return on investments.

Real Rate of Return = Actual Rate of Return – Inflation Rate

Inflation works to the effect of eroding the purchasing power of the principal invested and the investment income. It is clear that the level of inflation has an inverse relationship with the real rate of return. The real rate of return is inverse relation to the inflation rate of inflation thus, the higher the inflation rate, the lower the real rate of return. When the level of inflation is high it may cause a negative real rate of return on fixed income investment by the investor. 

For example, let the interest payment be 3% on a bond that was purchased by a bondholder while the inflation rate is at 5%, meaning that the bondholder is receiving a real rate of return of (-) 2%.