Fixed Income Mechanics
Fixed income securities are debt instruments that provide returns in the form of regular, or fixed, interest payments and repayments of principal at maturity. They serve as the ballast in institutional portfolios.
Duration & Convexity
Understanding price sensitivity to interest rate changes is paramount.
- Macaulay Duration: The weighted average time to receive all cash flows.
- Modified Duration: Measures price sensitivity. A bond with a duration of 5 will lose roughly 5% of its value if interest rates rise by 1%.
- Convexity: Measures the rate of change of duration as yields change. Bonds exhibit positive convexity (prices rise more when yields fall than they drop when yields rise).
The Yield Curve
The yield curve plots interest rates of bonds of equal credit quality but differing maturity dates. The most watched is the US Treasury yield curve.
Yield Curve States
- Normal: Upward sloping. Longer maturity bonds have higher yields to compensate for duration risk.
- Inverted: Downward sloping. Short-term yields are higher than long-term yields. Historically a strong predictor of economic recession.
- Flat: Minimal difference between short and long-term yields, often signaling economic transition.