What Is a Fixed Income Forward?

Afixed-income forward is a contract that lets investors buy or sell fixed-income securities, such as bonds, at a predetermined price on a future date. These agreements help lock in bond prices, offering a valuable tool for managing interest rate and market risks. Theseforward contracts are used to hedge against unfavorable price movements or to take advantage of expected changes in interest rates.

Understanding the Mechanics of Fixed Income Forwards

The risk of holding fixed-income forwards is that market interest rates for the bonds can change. These changes affect the bond’s yield and thus its price.Forward rates then become the focus of investor attention, especially if the market for the fixed-income security is consideredvolatile. A forward rate is the interest rate that’s applicable to a financial transaction that will take place in the future. 

Important Considerations for Using Fixed Income Forwards

How to Price a Fixed Income Forward Contract

To calculate the price of a fixed income forward contract you subtract thepresent value (PV) of coupon payments, over the life of the contract, from the bond price. This value is compounded by the risk-free rate over the life of the option. Therisk-free rate represents the interest an investor would expect from an entirely risk-free investment over a specified period.

The value of the contract is the bond price, less the present value of coupons, less the present value of the price which will be paid at expiration (bond price - PV coupons - PV price paid at expiration).

Strategies for Profiting with Fixed Income Forwards

Profiting from a fixed income forward depends on which side of the contract the investor is on. A buyer enters the contract hoping the market price of the bond will be higher in the future since the difference between the contracted price and themarket price represents profit. The seller expects that the bond price will fall.

While the number ofcoupon payments for the life of the bond may exceed the life of the contract, consideration is only on the payments due during the contract period. This payment limitation is caused by some bonds having maturities that are much longer than the duration of the contract. Participants use these contracts to hedge against short-term price movements.

Investors favor fixed income forwards to hedge against interest rate and other bond market risks. Other traders are attracted to the fixed income forward market to profit from anomalies between the forward andspot markets for bonds and other debt instruments.

Comparing Fixed Income Forwards and Futures

Fixed income derivatives may be traded onexchanges, where the underlying bond and terms of the contract are standardized. Unlike a forward contract that tradesover-the-counter (OTC),futures contracts are standardized and traded on exchanges. These exchanges publish these rates along with the types of bonds accepted as payment. Otherwise, forwards and futures operate in similar fashion.

The Bottom Line

A fixed-income forward contract lets traders agree on the future trade of fixed-income securities at a set price. This helps them manage interest rate and price volatility risks. Unlike standardized futures, forwards are customizable, which means they can be tailored to fit an investor's goals. These contracts are often used to protect against unfavorable rate changes or to capitalize on temporary market imbalances. The risks include interest rates that can significantly affect bond values and contract outcomes. Market movements and an investor’s positioning as a buyer or seller can determine how successful they are in this strategy.