Fixed Income & Credit

Chapter 2 covered equities. This chapter covers the asset class that's actually larger by total value and just as central to both banking (DCM, leveraged finance) and asset management: fixed income. What a bond actually is, how it's priced, what a yield curve means, and how credit risk gets priced into spreads.

What a bond actually is

A bond is a loan, packaged as a tradeable security. When you buy a bond, you're lending money to whoever issued it (a government, a company) in exchange for two things: regular interest payments (the coupon) and your money back at a fixed future date (the face value, paid at maturity).

That's it — the entire instrument is defined by three numbers: face value (usually $1,000 or $100 per bond, the amount you get back), coupon rate (the annual interest rate, paid on the face value), and maturity (when you get the face value back).

Why bond prices move opposite to interest rates

This is the single most important fixed-income intuition, so get it cold: when interest rates rise, existing bond prices fall — and vice versa.

Here's the mechanism: say you own a bond paying a 3% coupon. If new bonds start being issued paying 5% (because interest rates rose), nobody wants to buy your old 3% bond at its original price anymore — why would they, when they could get a new bond paying more? So the price of your old bond has to fall until its effective yield becomes competitive with the new 5% bonds. The coupon payment is fixed — it's the price that has to adjust.

Yield vs. coupon — not the same thing

The coupon rate is fixed at issuance and never changes. The yield is what you actually earn based on what you paid for the bond, which moves with its market price.

• Bond trading at face value (par): yield = coupon rate.
• Bond trading below face value (a "discount"): yield > coupon rate.
• Bond trading above face value (a "premium"): yield < coupon rate.

Yield to maturity (YTM) is the more complete version — the total annualized return you'd earn if you bought the bond today and held it to maturity. This is the number that actually gets quoted and compared across bonds.

The yield curve

Plot the yield of bonds from the same issuer (usually a government) against their maturities — 3-month, 2-year, 10-year, 30-year — and you get the yield curve.

Normal shape: longer maturities yield more than shorter ones — locking money up for longer carries more risk, so investors demand more yield to compensate.

Inverted yield curve: short-term yields exceed long-term yields — one of the most closely watched recession-warning signals in markets. The logic: if investors expect the central bank to cut rates sharply later (because they expect a slowdown), they'll accept a lower yield on long-dated bonds now to lock in today's still-higher rate before it disappears.

The policy rate you can look up in this site's own Central Bank Room is the anchor the short end of every yield curve is built around.

Credit spreads — pricing default risk

Not every bond has the same risk of the issuer failing to pay you back. The market prices that difference as a credit spread — the extra yield a risky bond pays over a same-maturity government bond.

• Investment grade (IG): rated BBB-/Baa3 or higher — lower default risk, tighter spreads.
• High yield (HY, "junk"): rated below that — real default risk, much wider spreads, and spreads widen sharply when investors get nervous ("credit spreads blowing out" is a classic recession-fear headline).

Duration — one number that tells you how much a bond's price will move

Duration, expressed in years, is a bond's sensitivity to rate changes. Rule of thumb: a bond with a duration of 7 will lose roughly 7% of its value if rates rise by 1 percentage point. Two things drive duration higher: longer maturity and lower coupon (a zero-coupon bond has the highest duration of all for its maturity, since all its value sits in one distant final payment).