Factors affecting trading in the fixed income trading market
Fixed-income investment has over the years become increasingly complex. It is imperative that those who develop fixed income strategies (economists, analysts, and strategists); those who implement strategies (asset managers and traders); and, ultimately, those who benefit from the strategies (individuals, corporates, and governments) do not lose sight of the risk involved.
Generally, risks have a large bearing on the returns that are generated from fixed-income investments. Knowing how to measure these risks and being able to differentiate the various components of return is also critically essential. Fixed income represents securitized debt instruments, involving the payment of interest in compensation for the use of borrowed funds.
The fixed income securities market is dominated by institutional investors, and there are different types of financial instruments that make up the fixed income market, but the most commonly traded are government or corporate bonds.
A robust fixed income trading solution would not only enable asset managers and traders lower transaction costs, maintain a competitive market structure, and a large, diverse collection of market participants, but would facilitate effective risk management and monitoring of returns.
Some factors affecting trading in the fixed income trading market
- Credit/Default risk: The probability that the issuer of a security may be unable to pay interest and/or principal in a timely fashion; Comply with the provisions of a bond indenture. Which mostly depends on the issuer’s ability to meet their financial obligations, and on their creditworthiness. A change in the issuer’s credit rating affects the value of their outstanding fixed income securities because the lower the issuer’s credit rating, the higher the yield (to compensate for higher credit risk) and vice-versa.
- Interest rate risk: Between the price of debt securities and interest rate there is a negative correlation. Interest rate risk arises when a change in interest rates has an adverse impact on the yield of debt securities. However, there is a positive relationship between interest rate and yield.
- Reinvestment rate risk: This refers to the probability of a decline in the interest rate causing a decline in the options available for reinvesting the interest income received at higher or similar rates in the market.
- Price risk: This is particularly relevant for investors who want to access the principal amount before the maturity date of the security, as they have to rely on the prevailing market price of the security, which may be higher or lower than the price they originally paid for the security. Price risk results when, due to an adverse movement in prices, the investor does not receive the expected price when selling a bond or other debt security in the secondary market.
- Purchasing Power Risk: Inflation reduces the purchasing power of the principal invested and the investment income. Meaning, if the inflation rate is high, there is a possibility that an investor’s real rate of return on their fixed income investment may be negative. For example, if a bondholder is receiving 3% interest payments on a purchased bond, but the inflation rate is 5%, then the bond holder’s real rate of return is negative (-) 2%.