Fixed income securities (also called debt securities) are instruments or promissory notes executed by or on the behalf of an issuer, who sells them to raise funds. Debt securities have a ‘maturity date’ and ‘face value’ and are transferable by the holder to other investors. Some debt securities also have embedded options in favor of the issuer and/or the buyer to facilitate premature retirement.
Term structure of interest rates refers to the relationship between maturities and yields in the bond market, particularly of the risk-free securities. It is fundamental to the management of fixed income portfolios. The most popular theories of term structure are:
Pure expectations theory – Yields differ with maturity because of market expectations of future changes in interest rates.
Liquidity preference theory – If yields were equal across maturities, investors will prefer shorter maturity bonds over longer maturity bonds.
Market segmentation theory – There are different investors in different maturity segments depending upon their maturity preference and asset-liability management needs and yields are independent of each other.
We know that coupon and maturity affect a debt security’s price volatility when the yield changes and that the level of interest rates affect price volatility. Duration is a measure that encompasses these three factors and is a measure of the price sensitivity of a bond. It can be interpreted as the approximate percentage price change of a bond for a 1 basis point change in the yield. Other measures are ‘Dollar duration’ and ‘Macaulay duration’.
Duration indicates that regardless of whether the yield rises or falls, the approximate price change is the same. However, this does not hold much water vis-à-vis a bond’s price volatility. Degrees of price change are different for an yield increase than they are for a fall in yield and this approximation is referred to as a bond’s convexity. Greater convexity is beneficial both for rising and falling yields.