An Equity Guy Thinks About Fixed Income

I was teaching basic fixed income principles to CFA Level I candidates last week. I am more of an equity person myself, but there is nothing like preparing material for students to make you think about the topic more deeply and what the connections are to other things that are more familiar.

To people more used to thinking about equity, fixed income often feels “backwards.” It is not too hard to understand the financial principles behind fixed income when they are explained to you, but later on, the intuitions that one develops about how external events and situations ought to affect valuation and yields somehow seem to lead to the wrong conclusions on a fairly regular basis. This blog piece identifies some of the reasons for the confusion so that fixed income analysis can feel more natural.

Equity looks at price; Fixed-income looks at yield

The reason why “fixed income” can feel “backwards” to the equity crowd is that equity analysis tends to focus on price, while fixed income analysis focuses more on yield. This is just a statement of tendencies, since equity analysts are also concerned with figuring out expected returns and fixed income analysts do look at prices as well. In the fixed income world, however, a bond’s price and its yield should be thought of as two measures of its worth; essentially identical, but presented in different scales and different units. A bond’s price and its yield are tied together by the size and timing of cash flows one expects to receive by holding it: when the yield goes up, the price goes down, and vice versa. Exactly how much they go up and down relative to each other depends on the specific sequence of cash flows and their timing, but it is computable, and our calculators or spreadsheets can do it quickly.

So something that is good for a company - something that should make the price of its equity rise - will generally make the price of its bonds rise also. This is where the equity analyst’s intuition is still helpful. However, fixed income prices and yields move in opposite directions, so this good news makes the bond’s yield fall. To equity people that sounds strange: shouldn’t good news make the return go up? Why then would it make the yield fall?

This is one dimension of the “backwardsness” issue: things that would make an equity price rise end up making bond yields fall. If this were all that one had to remember, it would probably not be so challenging; however, it is made more complex by the question of how to interpret the falling yield. After all, if something good has happened to the company, why would falling yield be good?

Why falling yields is good news for investors

Obviously, falling yields is good for the company, since it can issue debt more inexpensively, and as its weighted average cost of capital falls, its enterprise value should rise too. But if it’s good for the company, is it also good for the investor? The answer is yes, as long as you are already a bondholder.

That’s not all that different from the equity world after all: if the stock price rises, it’s good news if you already own the stock, but not if you don’t own the stock yet. If you own the stock, you realized a capital gain, but if not, the price has moved away from you and it’s too late to benefit from it (assuming no momentum effects).

What’s different about fixed income is that when you purchase a fixed income security, you are basically locking-in a level of yield at the time you invest. That’s something you simply can’t do with stocks. With stocks, you can estimate what kind of return you are likely to get, but it’s ultimately just an estimate and there’s little surety in what you will actually realize. With a typical fixed income security, you have locked in a yield when you invest. Maybe you will discover that you could have locked in a better yield by waiting or by buying a different security, but you do know what you will receive at the time that you invest.

Strictly speaking, the a bond’s yield isn’t perfectly locked-in, because there is typically a possibility of default, and there is often an assumption about the rates at which coupon payments can be reinvested, and this small bit is not perfectly predictable. But assuming that disaster doesn’t strike and you hold the investment to maturity, subsequent changes in interest rates and market yields don’t affect the yield you get (other than the reinvestment of any coupon payments). In other words, if you earn 6% on a bond, and the yield on that company’s debt later drops to 5%, you are still receiving a 6% yield on your initial investment, even if later investors in these bonds are getting less (they get less yield not because their income stream is different, but because they had to pay more to get that stream).

If you don’t hold a bond to maturity, then changes in market yields will affect the price you get when you sell. This is what is meant by interest rate risk, and it is measured by a bond’s duration (and convexity). Effectively, the capital gain or loss you receive when you sell a bond represents the present value of the difference between your yield and the current market yield for the remainder of the bond’s life. In other words, if you locked in 6% when you bought and the market is currently paying 5% for this company, the capital gain you realize when you sell a bond can be thought to represent the present value of of the (6%-5%) or 1% you would have received for the remaining time to maturity (plus the accumulation of any higher-than-market yields you’ve obtained in the past). The longer the time to maturity, the longer this stream of additional 1% payments would countinue, which is why bonds with longer times to maturity also have a higher (i.e. longer) duration.

If price and yield are both measures of a bond’s value, why focus on yield and not price?

If both yield and price are measures of value, why do fixed income analysts concentrate on yield instead of price, as equity analysts do? A big part of the answer is because fixed income securities mature, their prices will change over time, converging towards par values, even if nothing else about the company or the economy changes. Yields, on the other hand, should stay constant if economic and company conditions stay the same, even if the prices change over time due to accumulated interest. As a result, even if prices can be computed from yields at any point in time, using yields allows for more effective comparisons between fixed income securities. Comparing two bond yields tells you more about these bonds and in a clearer way than comparing two bond prices, because some part of the price difference may simply reflect small differences in maturity dates.

Of course, yields are not the only comparisons that matter, just as stock prices are only one factor in equity analysis. However, for fixed income, yields are a very useful starting point - and generally more useful than prices.

Think about why it’s called “fixed income”

An observation - perhaps obvious to those who have thought about it - yet a revelation to those who never have - is to consider why fixed income is called “fixed income.” Most CFA students think that “fixed income” is just a slightly-pompous sounding synonym for debt. This makes sense if you approach it from the perspective of the borrower, since debt/bonds is the other major (i.e. non-equity) part of a typical organization’s capital structure. But from the perspective of an investor, what’s more significant isn’t that the investment is debt, but rather that the income streams from owning the security have been “fixed” in advance. In an ordinary bond, they are fixed in absolute terms: coupon payments at specific times and principal payment at the end. In other situations (e.g. floating rate bonds) they may be fixed by a specified formula, but in either case, fixed income instruments generally have predefined payment structures.

Think about that for a moment, and what it means for the valuation process. If the income streams and timings are known in advance, the primary task for valuation is to determine the appropriate discount rate (i.e. yield) for computing the present value of those income streams. That discount rate will be composed of 1) the risk free rate (as a proxy for the time value of money) plus 2) a premium to compensate for any additional risks such as default, prepayment, etc.. When you think about it this way, one starts to understand why the behavior of interest rates and measures like duration, convexity, etc., are so central to managing fixed income investments. These represent the primary uncertainties that affect the security on a day-to-day basis.

Compare this to the process of valuing stocks. Like a bond, the value of a stock (and ideally its price) is also the NPV (Net Present Value) of all future cash flows that can be expected from owning it, but that’s where the similarities end. True, one needs a discount rate for those cash flows, and that discount rate is made up of the time value of money plus a set of risk premiums, but the uncertainties in determining the correct risk premium are at least on the same order, if not actually dwarfed by the uncertainties in determining what the cash flows are likely to be. Equity cash flows consist of dividend distributions and capital gains growth, and unlike a typical bond, there is no par value one can assume will materialize on some future date. Will company earnings grow? Will there be dividends? Will dividends be a constant proportion of earnings, or will they be smoothed? Will retained earnings be reinvested intelligently to generate capital appreciation, or will they be wasted in empire building? What about equity dilution or stock buybacks? Will there be P/E multiple expansions affecting terminal values?

All of these factors create major uncertainties about the stock value, over and above the appropriate discount rate. Compared to the challenges of determining appropriate equity values, one can see the advantages of having income streams “fixed” at the outset, and how doing this then requires a manager to focus their attention on interest rates, yield spreads, and a portfolio’s sensitivity to changes in these factors.