Fixed Income Made Simple: Types, Features, Risks and Returns You Must Know

Introduction

You deal with "fixed income" whenever a security promises regular or determinable income payments and return of principal at maturity (for example, government and corporate bonds, T‑bills, commercial paper and STRIPs). Understanding these instruments — their cash flows, pricing conventions and the valuation drivers that move them — is essential for advising clients, building portfolios and passing the CIRE exam.

Core Concepts (Recall)

• Fixed income: Securities that provide regular or determinable income payments and return of principal at maturity.
• Government of Canada bonds: Sovereign, benchmark debt paying fixed semi‑annual coupons; used to build the yield curve and price other debt.
• Corporate bonds: Issued by firms, pay coupons and principal but carry credit risk and therefore trade at a spread over government yields.
• STRIP: Coupon bonds separated into zero‑coupon components (each coupon and the principal trade separately).
• Treasury bills (T‑bills): Short‑term government debt sold at a discount; yields often quoted on a bank‑discount basis.
• Commercial paper (CP): Unsecured short‑term corporate promissory notes, typically maturing within 365 days.
• Coupon vs Yield: Coupon is the contractual interest; yield is the investor’s realized/expected return given price and cash flows.
• Valuation drivers: Interest‑rate/price risk, credit risk, liquidity risk, reinvestment risk, inflation risk and option risk.

Detailed Analysis (Understand)

Government bonds

Government of Canada securities form the sovereign benchmark and the risk‑free baseline used to price other debt. The government issues T‑bills, nominal coupon bonds across maturities and inflation‑indexed (real‑return) bonds. Coupon bonds pay semi‑annual coupons and are valued by discounting each semi‑annual coupon and principal using the market yield expressed on a semi‑annual compounding basis. Day‑count, settlement and coupon‑frequency conventions in government technical guides must be applied for correct pricing. For example, a 10‑year Government of Canada bond with a 2.00% coupon will trade below par if comparable market yields rise to 3.00% because fixed coupons are discounted at the higher market yield and longer maturity amplifies price sensitivity via duration.

Corporate bonds

Corporates pay higher yields to compensate for default probability, expected recovery and liquidity differences — the credit spread over the government curve. Issuer seniority, covenants, liquidity and embedded features (calls, puts, convertibility) materially affect pricing and regulatory treatment. Rating agency opinions influence demand and dealer behaviour. If a 10‑year government yield is 3.00% while a BBB‑rated corporate yields 4.50%, that 150 basis‑point spread compensates investors for non‑sovereign risks; a downgrade or funding shock that widens spreads will push the corporate bond’s price down relative to government debt.

STRIPs

STRIPs split a coupon bond into zero‑coupon pieces. Each strip is valued as the present value of a single future payment discounted at the appropriate zero‑coupon spot rate. Strips eliminate reinvestment risk because there are no interim coupons, but duration equals time to maturity so interest‑rate sensitivity per dollar of face value is high. In non‑registered accounts, holders face annual imputed (phantom) income taxes on accreted interest even though cash arrives only at maturity; strips often have wider bid–ask spreads and lower liquidity than the underlying coupon bonds.

T‑bills and commercial paper

T‑bills are discount instruments quoted on a bank‑discount basis (Canadian practice often uses a 365‑day year). A 180‑day T‑bill with $1,000 face and a quoted bank‑discount yield of 1.50% is priced approximately as 1,000 × (1 − 0.015×180/365) ≈ $992.60. To compare a discount‑quoted T‑bill with coupon bonds you must convert the discount yield to a bond‑equivalent or effective yield using the correct day‑count. Commercial paper pricing is driven by issuer credit and market demand; the CP market can seize up in stress, creating funding and liquidity risk.

Coupon vs yield and interest‑rate sensitivity

Coupon is contractual; yield depends on price. Common yield measures: current yield (annual coupon/price), yield to maturity (YTM, the IRR assuming coupons reinvested at the YTM), yield to call and yield to worst. Modified duration provides a first‑order price sensitivity estimate (ΔP/P ≈ −D_mod × Δy) and convexity adjusts for larger moves. Example: a bond with a 5.00% coupon and $1,000 face trading at $1,100 has a current yield of 50/1,100 = 4.545%; if modified duration is 8.5 and yields rise by 100 basis points, price falls approximately 8.5% before convexity.

Valuation best practice

Project all contractual cash flows, identify payment frequency and embedded options, then discount each payment using the appropriate spot/zero curve or an instrument‑specific curve plus credit spread. Use actual/365 for many Canadian short‑term instruments and semi‑annual compounding for coupon bonds. Use option‑adjusted valuation (binomial trees, risk‑neutral Monte Carlo or OAS frameworks) for callable/putable securities and report Macaulay/modified duration, convexity and credit metrics.

Market access and regulation

Most Canadian fixed‑income trading is OTC with electronic platforms (e.g., CanDeal) providing matching and transparency for many trades. Clearing/settlement is centralized through CDS Clearing and Depository Services Inc. with delivery‑versus‑payment. Settlement cycles vary (government commonly T+1; many corporate bonds T+2). Regulatory oversight includes provincial securities commissions and IIROC; dealer registration, blanket‑order exemptions (e.g., Blanket Order 31‑519 and 31‑512) impose rating and maturity conditions — always verify eligibility before trading.

Practical Application

• Liability matching: Buy a principal‑only STRIP maturing when a client’s liability falls due to zero reinvestment risk, but consider phantom tax in non‑registered accounts and lower liquidity.
• Risk‑reward check: Stress‑test a corporate bond for a one‑notch downgrade that widens spreads by 100 bps and compare the potential price loss to incremental yield earned over government debt.
• Trading operations: Before executing CP, confirm the instrument’s rating and maturity meet applicable blanket orders and verify CDS settlement and counterparty registration.

Key Takeaways

• Government of Canada securities are the benchmark — use correct day‑count and semi‑annual compounding.
• Corporate bonds offer higher yield for credit and liquidity risk; embedded features and seniority matter.
• STRIPs eliminate reinvestment risk but amplify duration and can create phantom tax.
• Convert T‑bill discount yields to bond‑equivalent yields for fair comparison with coupon bonds.
• Valuation = project cash flows + discount with appropriate curve/spread + apply OAS where needed.

Master these conventions and examples and you’ll be well equipped to value fixed income, advise clients and clear the exam pitfalls.