The fixed income portion of a portfolio is for income generation and asset preservation. Fixed income securities are debt securities that promise a stream of income for a certain time period (the term) at a specific rate of interest (the coupon rate). The current yield of a bond is the bond’s annual coupon rate divided by the bond price. This differs from the bond’s yield-to-maturity which is the interest rate that makes the present value of the bond’s coupon payments equal to its price. When we talk about “yield” we are typically referring to the yield-to-maturity of the debt instrument.
As investors, we are primarily concerned with how long (time to maturity) and how much (yield). How long do we have to tie up our money to earn a certain rate of interest? The relationship between yield and maturity is shown graphically in a yield curve which is a plot of yield to maturity as a function of time to maturity.
The shape of the yield curve indicates what might be expected in
future interest rates. As an indicator of future interest rate changes,
the yield curve can tell us a great deal about the strength or weakness
of the overall economy. A normal curve, represented by a positive
slope or rising line, reflects generally positive investor expectations
for the economy. The normal curve reflects what you expect to see in
the relationship between maturity and yield.
To entice investors to tie up their money for longer periods of time,
borrowers must pay higher interest rates. Thus, risk of the longer term
to maturity is compensated for by the additional return. In general,
the longer the maturity of the bond, the greater is the sensitivity of
bond price to fluctuations in the interest rate. The flattening at the
end of the curve depicts the marginal return associated with adding each additional year after that point in time. In general, we feel that the end of the normal yield curve does not adequately compensate investors and, thus, we favor bond maturities of less than 15 years.