Compare, Calculate, and Interpret Yiel ...
The fixed-income market is a multifaceted arena where various instruments are traded based on distinct classifications. These instruments can be broadly categorized based on three primary dimensions: time to maturity, issuer type, and credit quality. Additionally, classifications can be extended to encompass issuers’ geography, currency, and ESG (Environmental, Social, and Governance) characteristics.
Instruments in the fixed-income market can be segmented by their maturity duration:
Across these maturity spectrums, investors might also take on varying degrees of credit risk to augment returns.
The market sees a diverse range of issuers, each with its unique financial instruments:
Credit quality is assessed through credit ratings, which gauge an issuer’s ability to meet debt obligations based on default likelihood and potential loss. Key agencies like Standard & Poor’s (S&P) and Moody’s provide these ratings.
Investment Grade
Speculative Grade or High Yield:
BB to D: Ranges from less vulnerable in the short term to payment default or bankruptcy.
Developed market sovereign issuers, often with AAA ratings, are viewed as highly creditworthy. Their bonds are favored by foreign investors and central banks. Sovereign bonds also play a key role in domestic monetary policy.
Issuers rated BBB- (or Baa3 by Moody’s) and above are termed investment grade. Those rated BB+ (or Ba1 by Moody’s) and below are high-yield or junk. High-yield issuers, distinct from investment-grade ones, often represent new entities. Investors tend to demand collateral from them due to their inconsistent operating cash flows. Investment-grade issuers that have seen a decline in their credit quality after their initial issuance are referred to as fallen angels.
Question #1
Which of the following fixed-income instruments is most likely to be favored by pension funds and insurance companies due to its long-term maturity profile and fixed periodic coupon cash flows?
- Treasury bills
- Asset-Backed securities (ABS)
- Treasury bonds
Solution
The correct answer is C:
Treasury bonds fall under the long-term (>10 years) segment of the fixed-income market. Pension funds and insurance companies with long investment time horizons favor these fixed-income instruments due to their fixed periodic coupon cash flows and maturity profile that matches their long-term liabilities.
A is incorrect: Treasury bills are short-term instruments with a maturity of less than one year.
B is incorrect: Asset Backed securities (ABS) typically have an intermediate-term maturity of 1-10 years.
Question #2
Which of the following credit ratings from Standard & Poor’s (S&P) is most likely considered to be in the speculative grade or high yield category?
- A
- BBB
- BB
Solution
The correct answer is C:
BB is a rating that falls under the speculative grade or high yield category according to S&P’s credit ratings.
A is incorrect: “A” is considered to be investment grade and indicates a strong capacity with some vulnerability.
B is incorrect: “BBB” is the lowest investment grade rating, indicating adequate capacity with susceptibility to economic shifts.
Question #3
Which term refers to investment-grade issuers that experience a decline in their credit quality after their initial issuance?
- Fallen angels
- Junk bonds
- High-yield issuers
Solution
The correct answer is A.
Fallen angels refer to investment-grade issuers that have seen a decline in their credit quality after their initial issuance.
B is incorrect: Junk bonds refer to bonds that are rated below investment grade, but it doesn’t necessarily mean they were initially rated as investment grade.
C is incorrect: High-yield issuers are those that issue bonds rated as high yield or junk, but this term doesn’t specify the issuer’s initial rating.