Fixed income and credit

The bond market is several times the stock market's size and sets the price of money for everything else, including the discount rates in every equity model. It also analyzes many of the same companies with a colder question. Equity asks: how good can this get? Credit asks: how bad can this get and do I still get paid?

The seesaw: price and yield

A standard bond promises fixed coupons and principal at maturity. Since the payments are fixed, the price is just their present value, and the yield to maturity is the discount rate that makes that present value equal the current price. One object, read from two ends, which produces the market's most fundamental seesaw: when yields rise, existing bond prices fall, because old coupons must compete with new higher ones.

price = sum of coupon_t / (1 + y)^t  +  principal / (1 + y)^n

y (yield to maturity) and price are two readings of the same equation:
quote either, the other follows

Duration: the sensitivity number

Duration answers: if yields move one percentage point, how much does this bond's price move? A duration of 7 means roughly a 7% price fall per 1% yield rise. It grows with maturity and shrinks with coupon size, because more of a long zero-coupon bond's value sits far away where discounting bites hardest.

price change ≈ -duration x yield change (+ convexity correction)

30-year bond, duration ~20: a 1% rate rise costs ~20% of price.
This is why "safe" long bonds lost a third of their value in 2022.

Convexity is the curvature the linear estimate misses: bond prices fall less and rise more than duration predicts, an asymmetry investors will pay a little for. Portfolio managers speak in duration the way equity managers speak in beta; it is the dial for how much rate risk the book carries.

The yield curve: the market's macro forecast

Plot government yields against maturity and you get the yield curve, the most watched line in finance. Its shape is a forecast: an upward slope is the normal state (time and term risk cost money); a steepening curve says growth or inflation ahead; an inverted curve, short yields above long, says the market expects rate cuts, which historically means it expects a slowdown. Inversion has preceded most postwar US recessions, with lead times long and variable enough to punish anyone using it as a timing tool.

Credit spreads: the price of doubt

A corporate bond yields more than a government bond of the same maturity, and the difference, the credit spread, is the market's live estimate of default risk plus a premium for illiquidity. Spreads are quoted in basis points and move like a fear gauge: high-yield spreads near 300bp say calm; near 800bp they say recession; above 1,000bp, crisis.

corporate yield = treasury yield + credit spread

expected loss ≈ probability of default x (1 - recovery rate)
a spread persistently above expected loss is the credit investor's edge,
and the reason selling panic is historically well paid

How a credit analyst underwrites a borrower

Credit work is equity analysis with the optimism removed and the documents added:

• Leverage and coverage. Net debt / EBITDA (how many years of earnings to repay) and EBIT / interest (how comfortably the coupon is paid). Every credit committee starts here.
• The maturity wall. WHEN debt comes due matters as much as how much. A fine company with everything maturing next year in a shut market is a default candidate; the debt footnote publishes the schedule.
• Seniority and security. Who stands where in bankruptcy: secured lenders, then unsecured bondholders, then subordinated, then equity. The same company's different bonds can deserve opposite verdicts.
• Covenants. The contract's tripwires: leverage ceilings, payout restrictions, collateral rules. Weak covenants (the norm in hot markets) mean lenders discover problems late.
• The downside case. Credit models stress the bad scenario first, because the upside is capped at par: a lender's best outcome is getting exactly what was promised.

What bonds do in a portfolio

Three jobs, in tension: income (the yield you are paid to wait), ballast (high-grade bonds have often risen when stocks fell, though 2022 proved the correlation flips when inflation is the shock), and dry powder (short-duration paper holds value to redeploy in a selloff). The professional decision is not "bonds or not" but which risks the bond sleeve should carry: duration risk, credit risk, both, or neither.