Fixed Income Trading Strategy & Education
Fixed Income Strategy and Education Essentials
What is rule 72?
The Rule of 72 is a simple way to determine how long an investment will take to double given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors obtain a rough estimate of how many years it will take for the initial investment to duplicate itself.
For example, the Rule of 72 states that $1 invested at an annual fixed interest rate of 10% would take 7.2 years ((72/10) = 7.2) to grow to $2. In reality, a 10% investment will take 7.3 years to double ((1.107.3 = 2).
What's the difference between yield to maturity and coupon rate?
The yield to maturity (YTM) is the percentage rate of return for a bond assuming that the investor holds the asset until its maturity date. It is the sum of all of its remaining coupon payments. A bond's yield to maturity rises or falls depending on its market value and how many payments remain to be made. The coupon rate is the annual amount of interest that the owner of the bond will receive. Generally, a bond investor is more likely to base a decision on an instrument's coupon rate. A bond trader is more likely to consider its yield to maturity. To complicate things, the coupon rate may also be referred to as the yield from the bond.
How do I calculate zero coupon bond yield?
Yield to maturity (YTM) tells bonds investors what their total return would be if they held the bond until maturity. YTM takes into account the regular coupon payments made plus the return of principal. As a result, YTM calculations for zero-coupon bonds differ from traditional bonds. The formula for calculating the yield to maturity on a zero-coupon bond is:
Yield To Maturity = (Face Value/Current Bond Price)^(1/Years To Maturity)−1
What's the difference between Macaulay duration and modified duration?
There are a few different ways to approach the concept of duration, or a fixed-income asset's price sensitivity to changes in interest rates. The Macaulay duration is the weighted average term to maturity of the cash flows from a bond, and is frequently used by portfolio managers who use an immunization strategy. The modified duration of a bond is an adjusted version of the Macaulay duration and is used to calculate the changes in a bond's duration and price for each percentage change in the yield to maturity.
How are duration and convexity used to measure bond risk?
Duration and convexity are two tools used to manage the risk exposure of fixed-income investments. Duration measures the bond's sensitivity to interest rate changes. Convexity relates to the interaction between a bond's price and its yield as it experiences changes in interest rates. With coupon bonds, investors rely on a metric known as duration to measure a bond's price sensitivity to changes in interest rates. Using a gap management tool, banks can equate the durations of assets and liabilities, effectively immunizing their overall position from interest rate movements.
A repurchase agreement, or repo, is a short-term agreement to sell securities in order to buy them back at a slightly higher price. The one selling the repo is effectively borrowing and the other party is lending, since the lender is credited the implicit interest in the difference in prices from initiation to repurchase. Repos and reverse repos are thus used for short-term borrowing and lending, often with a tenor of overnight to 48 hours.
A debenture is a type of debt instrument that is not backed by any collateral and usually has a term greater than 10 years. Debentures are backed only by the creditworthiness and reputation of the issuer. Both corporations and governments frequently issue debentures to raise capital or funds.
Inverted Yield Curve
An inverted yield curve occurs when short-term debt instruments have higher yields than long-term instruments of the same credit risk profile. An inverted yield curve is unusual; it reflects bond investors' expectations for a decline in longer-term interest rates, typically associated with recessions.
A Treasury Bill (T-Bill) is a short-term debt obligation backed by the U.S. Treasury Department with a maturity of one year or less. Treasury bills are usually sold in denominations of $1,000 while some can reach a maximum denomination of $5 million. The longer the maturity date, the higher the interest rate that the T-Bill will pay to the investor.
Yield curves plot interest rates of bonds of equal credit and different maturities. Yield curve rates are published on the Treasury’s website each trading day. The three key types of yield curves include normal, inverted, and flat. Upward sloping (also known as normal yield curves) is where longer-term bonds have higher yields than short-term ones. While normal curves point to economic expansion, downward sloping (inverted) curves point to economic recession.
Accrued interest is a feature of accrual accounting, and it follows the guidelines of the revenue recognition and matching principles of accounting. Accrued interest is booked at the end of an accounting period as an adjusting journal entry, which reverses the first day of the following period. The amount of accrued interest to be recorded is the accumulated interest that has yet to be paid as of the end date of an accounting period.