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Fixed income valuation refers to the valuation of debt securities and the analysis of risks associated with their interest rates. In addition, it involves the analysis of credit risk and the possibility of price behaviour in hedging sets. Having conducted the analysis, one might decide whether to buy, sell, hold, hedge, or keep away from a given security.
Valuation Techniques for Fixed Income Securities
The cash-flow matching method is one of the fixed income valuation techniques. The method involves matching the liability profile with the assets of the appropriate maturities. This technique involves little risk. However, it does not provide more room for extra returns. Opportunities to earn extra income emerge whenever there are deviations from the given maturity of the liabilities. The positively sloped structure of interest rates provides the advantage required to earn extra incomes. To minimize the possibility of failure to meet the liabilities, the asset duration is constantly adjusted. Similarly, investment income can be improved by taking more credit risk. However, there is a problem of monitoring the credit quality of bond issuers, which require significant resources that a company may not be willing to build up and maintain (Jun & Malkiel 2010, p. 23).
Another fixed income valuation technique is the adjusted present value approach. According to it, the effects of the value of debt financing are separated from the value of the assets of a business. Unlike the usual methods that capture the effects of debt financing in the discount rate, the adjusted present value approach estimates the dollar value of debt benefits as well as costs separated from the value of operating assets (Arnott, Hsu, Li & Shepherd 2010, p. 5).
The Relationship Between Bonds and the Prevailing Yields
Asset returns can be boosted by buying a comparatively new fixed-income security generation. Such securities usually contain the usual fixed-income part and features that make their cash-flow uncertain. As a result, they yield higher returns than the older generation fixed-income securities with similar credit qualities. There are a number of fixed income securities that have an uncertain cash flow. First, there is a callable bond, whose buyer acquires a traditional fixed income security and, at the same time, has an alternative of selling a call option to an issuer (Arnott et al. 2010, p. 9). It is notable that a call option permits an issuer to buy back the bond before it matures at a fixed price. Further, there is a puttable bond, whose buyer acquires a traditional fixed asset security and a put option. A put option allows a bond holder to sell a bond back to an issuer before the stated maturity date at a fixed price.
There are also various combinations of bonds, such as sinking-fund bonds and bonds that are securitized from pools of mortgages. Notably, sinking funds usually comprise a compulsory schedule of nominal amounts that an issuer has to buy back in the course of time. Importantly, the timing and the prices of the redemptions are stipulated in the prospectus. Apart from compulsory sinks, there can also be other sinking provisions, such as to double up. Such a provision confers to an issuer the right to make redemptions twice compared to what is stipulated in the prospectus. The open market option allows the issuer to buy back a bond in the secondary market instead of calling all bond holders. This option does not guarantee the bond holder that his holdings will be retired as per a mandatory sink plan (Sigh & Uzma 2010, p. 59).
The variety of bonds that are securitized from pools of mortgages often serves as collateral. Pass-throughs that often pass directly through cash flows, which have been received from mortgage holders, are considered simpler structures. Mortgage holders are accorded the right to prepay part or their entire mortgage. Thus, there is room for scheduled or unscheduled principle payments. Such repayment options rely heavily on the movement of interest rates.
There is a number of techniques that are applicable in fixed income evaluation. These techniques are quite important in maintaining the balance of economy, as the Greek sovereign debt crisis has shown recently. Through these techniques, buyers and issuers can decide when to sell or buy income securities. This way, they are able to minimize losses.