Learning Objectives:

  • Understand the fundamentals of fixed income securities.

  • Apply bond valuation and yield calculation techniques.

  • Analyse credit spreads and their determinants.

  • Understand the role of fixed income in treasury portfolios.

4.1 Bond Fundamentals

Bonds are debt securities that pay periodic interest (coupon) and return principal at maturity. The ICAI materials note that the Research Department in treasury conducts “Research Activities / Analysis in various types of securities” including bonds . The HKSI Bank Treasury Management programme covers “a bank’s assets” and “a bank’s liabilities,” which include fixed income securities .

Key Bond Features:

  • Face Value (Par Value): The principal amount repaid at maturity.

  • Coupon Rate: The annual interest rate paid on the face value. Fixed coupons and floating/adjustable rates are common.

  • Maturity: The date on which the bond matures and principal is repaid.

  • Yield to Maturity (YTM): The total return anticipated if held to maturity.

  • Credit Spread: The difference between the yield on a corporate bond and a risk-free government bond, reflecting credit risk.

4.2 Bond Valuation

Bond valuation involves discounting expected cash flows (coupon payments and principal) at the appropriate discount rate. The ICAI materials note that the Research Department conducts “Research Activities / Analysis in various types of securities” .

Key Valuation Concepts:

  • Present Value: The sum of discounted coupon payments and principal.

  • Yield Curve: The relationship between yields and maturities. The Research Department would analyse “various types of securities” including those across different maturities .

  • Duration: A measure of price sensitivity to interest rate changes. The mid-office is responsible for “marking open positions to market to assess unrealised gain and losses” .

  • Convexity: A measure of the curvature in the price-yield relationship.

4.3 Credit Risk and Credit Spreads

Credit risk is the risk of default by the bond issuer. The University of Reading’s investment policy includes explicit “exclusionary screens” for companies involved in “fossil fuels,” “oil and gas,” and other areas, reflecting credit as well as ethical considerations .

Credit Spread Determinants:

  • Credit Quality: Higher default risk leads to wider spreads.

  • Economic Conditions: Spreads widen during recessions.

  • Liquidity: Less liquid bonds trade at wider spreads.

  • Maturity: Longer-maturity bonds typically have wider spreads.

 

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