on October 06, 2016 Trading & Investing

What is Fixed Income?

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It surprised me to learn that the fixed income market is the largest securities market in the world, eclipsing sharemarkets by a fair margin. But when you think about it (clearly I hadn’t), it makes sense.

Companies issue shares. Fixed income securities are issued by governments, government authorities and corporates. Loans and other financial instruments are packaged up by investment banks and sold as a higher risk form of fixed income.

While it was hard to find an exact figure, most estimates suggest that globally, the bond market exceeds US$100 trillion, while equity market capitalisation sits around US$70 trillion.

In short, there is more debt in the world than equity.

 

What is fixed income?

Fixed income investments have long held a central role in a diversified portfolio. Whether government or corporate bonds, or shorter-dated bank bills, fixed income is an important source of income and diversification for investors.

Described by some as a form of IOU, a fixed income investment is a loan made by an investor to a government or corporate borrower in exchange for a fixed rate of interest for a fixed amount of time...hence such investments are called fixed income or fixed interest securities.

Fixed income is probably the most jargon-laden asset class, so here’s a quick glossary:

  • Issuer: The entity that sells fixed income securities to raise money for its operations. Issuers are responsible for making interest or coupon payments and to repay the ‘loan’ amount in full when the security matures.
  • Coupon: The interest rate of a fixed income security upon issue.
  • Maturity: The time period at which a fixed income security will be repaid in full by the issuer.
  • Par value: the face value of a fixed income security. Par value determines the maturity value and coupon payments of the security.
  • Pull to par: The movement of a fixed income security's price toward its par value as it approaches its maturity date. 
  • Duration: A measure of the sensitivity of the price of a fixed-income security to a change in interest rates; generally, the longer the duration, the more sensitive the security is to interest rate increases.

Fixed income does not require a buyer to determine value. Property, shares, gold and other commodities – all are priced according to what investors are willing to way. Not so with fixed income. 

At the maturity date, the issuer promises to return the principal amount of each fixed income security to the investor. Bonds have a natural buyer in the issuer, who is required to pay back the loan (bond) at par value – i.e. the maturity value of a bond – when it reaches its stated maturity date. This gives bonds a greater predictability of returns.

Another benefit of having this natural buyer is that bonds that have sold off (i.e. dropped in value) will naturally ‘pull to par’ or pull back to their par value as the maturity date approaches.

This might be more easily explained with an example. In 2014, Amazon issued US$6 billion in corporate bonds, the biggest bond issue ever for an online retailer. If along the way, Amazon was to release a poor earnings report, both its stock and bond prices would, most likely, react negatively. Over time, the bonds will improve in price as the maturity date approaches, while the share price could wallow in the mire indefinitely because there is no natural buyer for the stock – only what someone in the market is willing to pay.

It is incumbent on the issuer of a fixed income security to return capital in full – a stock has no such requirement.

It’s important to note that not all interest rates on fixed income investments are fixed. Some can fluctuate, comparable to a variable home loan. And as with any investment, some fixed income assets pay higher returns than others, but they generally come with a higher risk of loss. As with any investment, higher risk should equate to higher returns.

 Risk_V_Reward.jpg

 Source: XTB 

 

Not all fixed income is created equal

These fixed income securities are generally available in all developed economies, as well as a number of developing economies. The names of the securities sometimes vary.

Types of fixed income products
Listed:  
Hybrids Securities traded on the ASX that are issued by corporates and are often a combination of fixed income and equity, such as convertible preference shares. A Hybrid security might perform like a bond by paying regular income, but its capital value may be affected by its share price movements.
Exchanged traded bonds (XTBs) Securities traded on ASX. XTBs bring together the predictable income and capital stability of corporate bonds, with the transparency and liquidity of the ASX market. They provide exposure to specific individual corporate bonds issued in the wholesale market.
Unlisted:  
Government or treasury bonds Issued by national governments, including Australia’s federal government; these bonds are often viewed as ‘risk free’ and therefore generally offer the lowest return; referred to as US Treasuries in the United States and Gilts in the United Kingdom
Semi-government bonds: Issued by the governments of Australia’s states and territories; referred to as municipal bonds in the US.
Corporate bonds Issued by companies and rank above equity in the capital structure of a company; if a company becomes insolvent, the proceeds of any liquidated assets will be paid to bond holders ahead of shareholders
Investment-grade corporate bonds Issued by corporations deemed to be in good financial condition by the major credit rating agencies and most likely to meet payment obligations
High yield bonds: Sometimes go by the name junk bonds, these bonds are issued by corporations considered to be at higher risk of default - i.e. more likely to miss payments of interest or principal
Inflation-linked bonds issued by governments and operators of infrastructure projects, these bonds generally pay a lower interest rate as the capital value of an investment is expected to increase with inflation
Money market instruments thought to be relatively low risk because maturities are usually very short, these instruments are generally issued by governments and corporates and include 90-day bills and treasury notes

 

How do bonds work?

If an investor was to buy a 10 year fixed income security at issue for $100, receive an interest rate (or coupon) of 5%, and hold it to maturity, it would look like this:

Bonds_coupons_flow.png

If that investor was to sell the bond before the maturity date, they may get more or less than they paid when the bond was issued. This is because the price of fixed income securities has an inverse relationship to interest rates; bond prices and interest rates tend to move in opposite directions.

When interest rates rise, bond prices fall; when interest rates fall, bond prices rise. Using the $100 bond example again, a change in interest rates results in the following changes to bond prices:

Interest rate Bond price
4% $108.18
5% $100
6% $92.56

 

The secondary market

As with shares, once a fixed income security has been issued, its value (before maturity) is determined by the secondary market. Factors that feed into its price include:

The prevailing interest rate environment

As those of us with mortgages or savings know, interest rates are at all-time lows. When the Bank of England dropped its rate in August this year, it was to a low not seen in the Bank’s 322 year history. One of the major concerns expressed in the media following this rate cut was the impact on pension funds that invest in UK Gilts (government bonds) to provide an income stream to annuity holders.

A bond’s price reflects the value of the income that it provides through its regular coupon interest payments. As interest rates drop, the price of bonds rise and older bonds become more valuable because they were sold in a higher interest rate environment and generally have higher coupons.

Country/region

Current rate

Direction

Previous rate

Date of change

United States

0.500 %

 

0.250 %

16 Dec 2015

Australia

1.500 %

 ⇓

1.750 %

2 Aug 2016

Great Britain

0.250 %

 ⇓

0.500 %

4 Aug 2016

Canada

0.500 %

 ⇓

0.750 %

15 July 2015

China

4.350 %

 ⇓

4.600 %

23 Oct 2015

Europe

0.000 %

 ⇓

0.050 %

10 Mar 2016

Japan

0.000 %

 ⇓

0.100 %

1 Feb 2016

Switzerland

-0.750 %

 ⇓

-0.500 %

15 Jan 2015

Source: http://www.global-rates.com/interest-rates/central-banks/central-banks.aspx

Default risk

Credit agencies such as Moody’s provide ratings on fixed income securities. While default risk is (generally!) low for government issued bonds, it can be higher for corporate bonds. If there’s a risk premium priced into a company’s shares, it’s likely to be priced into their bonds too.

Time to maturity

A key benefit of investing in fixed income is the ‘natural buyer’ (the issuer) and the ‘pull to par’ effect, where bonds generally return to their par value as the maturity date approaches.


Fixed income is complex. The calculations to determine bond pricing are mind boggling and best left to the experts, although a quick Google search returns a plethora of bond calculators online or see XTBs Yield Calculator. There has been significant innovation in recent years, notably the rise of exchange traded fixed income products, the new frontier of fixed income investing.

 

Tracey Franks (OM blogger)

Tracey Franks is an experienced freelance writer, communicator and marketer. She has worked in financial services for over 20 years, for businesses spanning stockbroking, funds management, research and consulting, as well as financial planning. When not writing about finance-related topics, Tracey is working on her first novel.