1.2.2 Fixed Income

Welcome to On Judgement. A bond pays a £5 annual coupon per £100 face value. Its market price falls to £80. Has the issuer automatically increased its promised interest? Explain your initial view. Take a first view. You can change it when you have considered the evidence.

A conventional bond is borrowing divided into securities. Its terms identify the issuer, face value or principal, interest arrangements and maturity. A fixed coupon is an amount based on the terms, not a fixed percentage of each investor’s purchase price. Some bonds have floating payments, inflation linkage or other structures; this lesson’s calculations concern a simple fixed-coupon bond. Repayment is contractual, not certain. Credit analysis asks how cash will be generated to meet interest and principal. Seniority determines relative ranking; security creates claims over specified collateral under the terms. Neither guarantees full recovery. Government debt also differs by issuer, currency, maturity and legal setting.

The coupon rate is annual coupon divided by face value. Current yield is annual coupon divided by current price. Yield to maturity summarises the discount rate equating a bond’s price with promised future payments under specified assumptions. Realised return depends on actual payments, prices, timing and reinvestment. These measures should not be substituted for one another. An investor can earn a coupon and still lose overall if the sale price falls far enough. Buying below face value may create a capital gain if full repayment occurs, but default or a sale before maturity can change the outcome. Current yield omits that capital gain or loss.

For otherwise unchanged fixed cash flows, a higher required yield implies a lower present price. A bond paying an old fixed coupon must compete with the returns available on comparable investments. Interest-rate expectations, inflation and compensation for credit and liquidity risk can all affect required yield. Longer-dated fixed payments are often more sensitive to yield changes, but maturity alone does not establish a universal risk ranking. Coupon, embedded options, credit quality and starting yield matter. A downgrade may reduce a price if it conveys adverse information, but a fully anticipated announcement need not cause a new fall.

Credit ratings are opinions based on methods and information, not repayment guarantees. Different agencies use different scales. A borrower’s cash flow, debt burden, resilience and refinancing needs matter more than memorising an undated country ranking. Compare the issuer and instrument on a dated, consistent basis. Bonds may provide contractual income, duration exposure or diversification within a mandate. Stocks and bonds can fall together, particularly in some inflation and rate shocks. A 60/40 label is an allocation description, not a rule that suits every owner. A green use-of-proceeds label concerns specified financing purposes; it does not remove credit risk.

Let's work through Coupon, yield and the actual holding period. A £100-face fixed bond pays £5 annually. An investor buys for £80 and sells one year later for £78 immediately after receiving one coupon. Ignore all costs and tax. Pause here and try the calculation or reasoning before continuing.

Coupon rate: £5 ÷ £100 = 5%. Current yield at purchase: £5 ÷ £80 = 6.25%. One-year total return: (£78 − £80 + £5) ÷ £80 = 3.75%. The sale price and received coupon determine this return; 6.25% was not the realised total return.

The issuer did not automatically change the £5 coupon when the price fell. Yield to maturity needs all remaining promised payments and their dates; this example does not calculate it.

Now try the choices in this lesson. If your answer changes, identify the reason. Explain how required yields and credit news can change a conventional bond’s price. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.