Fixed Income Trading Strategy & Education

The Rule of 72 is a simple way to determine how long an investment will take to double given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors obtain a rough estimate of how many years it will take for the initial investment to duplicate itself.

For example, the Rule of 72 states that $1 invested at an annual fixed interest rate of 10% would take 7.2 years ((72/10) = 7.2) to grow to $2. In reality, a 10% investment will take 7.3 years to double ((1.107.3 = 2).

The yield to maturity (YTM) is the percentage rate of return for a bond assuming that the investor holds the asset until its maturity date. It is the sum of all of its remaining coupon payments. A bond's yield to maturity rises or falls depending on its market value and how many payments remain to be made. The coupon rate is the annual amount of interest that the owner of the bond will receive. Generally, a bond investor is more likely to base a decision on an instrument's coupon rate. A bond trader is more likely to consider its yield to maturity. To complicate things, the coupon rate may also be referred to as the yield from the bond.

Yield to maturity (YTM) tells bonds investors what their total return would be if they held the bond until maturity. YTM takes into account the regular coupon payments made plus the return of principal. As a result, YTM calculations for zero-coupon bonds differ from traditional bonds. The formula for calculating the yield to maturity on a zero-coupon bond is:

Yield To Maturity = (Face Value/Current Bond Price)^(1/Years To Maturity)−1

There are a few different ways to approach the concept of duration, or a fixed-income asset's price sensitivity to changes in interest rates. The Macaulay duration is the weighted average term to maturity of the cash flows from a bond, and is frequently used by portfolio managers who use an immunization strategy. The modified duration of a bond is an adjusted version of the Macaulay duration and is used to calculate the changes in a bond's duration and price for each percentage change in the yield to maturity.

Duration and convexity are two tools used to manage the risk exposure of fixed-income investments. Duration measures the bond's sensitivity to interest rate changes. Convexity relates to the interaction between a bond's price and its yield as it experiences changes in interest rates. With coupon bonds, investors rely on a metric known as duration to measure a bond's price sensitivity to changes in interest rates. Using a gap management tool, banks can equate the durations of assets and liabilities, effectively immunizing their overall position from interest rate movements.