Fixed income foundations for the CFA

Published on August 31, 2020   16 min
Hello and welcome to our fixed income foundations talk. I'm Professor Michael McDonald. I'm a professor of finance at Fairfield University in Fairfield, Connecticut. Today, I'd like to talk to you about the elements of fixed income that you need to know as a financial professional, especially if you're considering taking the CFA exam. Let's get started. Now, when it comes to fixed income or bonds,
more prosaic, the reality is that bonds aren't considered as exciting or as sexy in some sense as stocks are. But, they're still an important aspect of the financial markets and certainly of the CFA exam. So, you'll need to understand, if you're going to work in finance, the different features of bonds. In particular, there are five primary characteristics of a bond that every finance professional should know: coupon, maturity, yield, par value, and price. Each of these features impacts the value of the bond in a different way. The coupon is the amount that the bondholder receives each year or every half year in income. Essentially, it drives how much a bondholder earns in interest, essentially, on their investment. Maturity is the life of the bond. That's how long the bond is going to be outstanding for. We can have a longer term bond, which in theory is good because it means there's lower reinvestment risk, but it also means that you're exposed to greater interest rate risk. If interest rates rise, that bond becomes relatively less attractive, but it's still outstanding for a very long period of time. So there's a balance between whether you want a short maturity bond or a long maturity bond; each of them carries their own unique set of risks. Third, we have the yield. Now, there are multiple different methods of measuring yield: nominal yield, current yield, yield to maturity, things like that. But, essentially, the yield is simply going to measure the rate of return that we get on a bond overall. In particular, the most important yield for you to be familiar with is the yield to maturity. It's the rate of return that you earn over the life of a bond. In contrast, the nominal yield and the current yield are simply metrics that we use to look at the relative rate of return on a bond compared to its price versus its coupon, for instance, or based on its price versus its par value, etc. Speaking of par value, it's the fourth feature you need to know when it comes to bonds. The par value is just how much money you'll get out of the bond at maturity. Now, typically, it's going to be $1,000. That's not always going to be the case, there's a lot of bonds out there and there are exceptions, but normally, a bond's par value is $1,000. So I might buy the bond for, say, 900, but at maturity, I get 1,000. Finally, we have a bond's price. The bond's price is simply how much you paid for that bond upfront. Now, we measure a bond's price in dollar terms; we measure the price of anything in dollar terms. But when we're talking about bonds, you usually see the price quoted based on a percentage of par. You'll frequently see a bond's price listed as something like 95. Well, that means 95 percent of par value, so if the par value is 1,000, the price of that bond would actually be $950. So when we're talking about price, we'll often see it quoted as if it's a percentage, but without the percentage sign. You just need to be aware that ultimately at the end of the day, it's still a dollar value that you're paying for that bond, itself.