Fixed-income Segments, Issuers, and Investors

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.

Time to Maturity

Instruments in the fixed-income market can be segmented by their maturity duration:

1. Short-term (< 1 year): Instruments in this category, such as Treasury bills, Repo, and commercial paper, cater to near-term obligations. Investors seeking liquid cash alternatives often turn to these money market securities.
2. Intermediate-term (1-10 years): Instruments like Treasury notes, Asset-Backed securities (ABS), and unsecured corporate bonds fall under this segment. Investors looking to match the cash flows of known future obligations might consider these instruments.
3. Long-term (> 10 years): This segment comprises Treasury bonds and mortgage-backed securities. 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 match their long-term liabilities.

Across these maturity spectrums, investors might also take on varying degrees of credit risk to augment returns.

Issuer Type

The market sees a diverse range of issuers, each with its unique financial instruments:

1. Sovereign governments: These issuers, especially from developed markets, are often perceived as having the lowest credit risk. Their bonds, such as Treasury bills, notes, and bonds, are widely held by foreign investors and central banks.
2. Corporations: Companies, exemplified by entities like Apple Inc., issue a variety of fixed-income instruments, ranging from short-term commercial paper to long-term bonds, to finance their operations.

Credit Quality

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.

S&P Credit Ratings

Investment Grade

1. AAA: Highest credit quality.
2. AA: Very strong capacity.
3. A: Strong but with some vulnerability.
4. BBB: Adequate capacity with susceptibility to economic shifts.

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. Foreign investors and central banks favor their bonds. 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?

1. Treasury bills.
2. Asset-backed securities (ABS).
3. 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 match 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?

1. A.
2. BBB.
3. 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?

1. Fallen angels.
2. Junk bonds.
3. 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.