Fixed income

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Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable.

For example, if you lend money to a borrower and the borrower has to pay interest once a month, you have been issued a fixed-income security. Governments issue government bonds in their own currency and sovereign bonds in foreign currencies. Local governments issue municipal bonds to finance themselves. Debt issued by government-backed agencies is called an agency bond. Companies can issue a corporate bond or get money from a bank through a corporate loan ("preferred stock" can be "fixed income" in some contexts). Securitized bank lending (e.g. credit card debt, car loans or mortgages) can be structured into other types of fixed income products such as ABS – asset-backed securities which can be traded on exchanges just like corporate and government bonds.

The term fixed income is also applied to a person's income that does not vary with each period. This can include income derived from fixed-income investments such as bonds and preferred stocks or pensions that guarantee a fixed income. When pensioners or retirees are dependent on their pension as their dominant source of income, the term "fixed income" can also carry the implication that they have relatively limited discretionary income or have little financial freedom to make large expenditures.

Fixed-income securities can be contrasted with equity securities that create no obligation to pay dividends, such as stocks. In order for a company to grow as a business, it often must raise money; to finance an acquisition, buy equipment or land or invest in new product development. Investors will give money to the company only if they believe that they will be given something in return commensurate with the risk profile of the company. The company can either pledge a part of itself, by giving equity in the company (stock), or the company can give a promise to pay regular interest and repay principal on the loan (bond, bank loan, or preferred stock).

The term "fixed" in "fixed income" refers only to the schedule of obligatory payments, not the amount. "Fixed income securities" include inflation linked bonds, variable-interest rate notes, and the like. If an issuer misses a payment on a fixed income security, the issuer is in default, and the payees can force the issuer into bankruptcy. In contrast, if a company misses a quarterly dividend to stock (non-fixed-income) shareholders, there is no violation of any payment covenant, and no default.

Terminology

While a bond is simply a promise to pay interest on borrowed money, there is some important terminology used by the fixed-income industry:

• The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and pays the interest.
• The principal of a bond – also known as maturity value, face value, par value – is the amount that the issuer borrows which must be repaid to the lender.
• The coupon (of a bond) is the interest that the issuer must pay.
• The maturity is the end of the bond, the date that the issuer must return the principal.
• The issue is another term for the bond itself.
• The indenture is the contract that states all of the terms of the bond.

Investors

Investors in fixed-income securities are typically looking for a constant and secure return on their investment. For example, a retired person might like to receive a regular dependable payment to live on, but not consume principal. This person can buy a bond with their money, and use the coupon payment (the interest) as that regular dependable payment. When the bond matures or is refinanced, the person will have their money returned to them.

Pricing factors

Fixed income investments such as bonds and loans are generally priced as a credit spread above a low-risk reference rate, such as LIBOR or U.S. or German Government Bonds of the same duration. For example, if a 30 year mortgage is available for 5% and 30 year U.S. treasuries yield 3%, the credit spread is 2%. The credit spread reflects the risk of default and profits for lenders, while the low-risk reference rate reflects other factors that may drive interest rates. Risk free Interest rates change over time, based on a variety of factors, particularly base rates set by central banks such as the US Federal Reserve, UK Bank of England, and Euro Zone ECB. If the coupon on the bond is lower than the prevailing interest rate, then this pushes the price down, and conversely, low interest rates increase the attractiveness of a given coupon, and so increase the price.

In buying a bond, one is in effect buying a set of cash flows, which are discounted according to the buyer's perception of how interest and exchange rates will move over its life.

Supply and demand affect prices, especially in the case of market participants which are constrained in the set of investments they make. Insurance companies often have long term liabilities that they wish to hedge, which requires low risk, predictable cash flows, such as long dated government bonds.

Inflation-linked bonds

There are also inflation-indexed bonds, fixed-income securities linked to a specific price index. The most common examples are US Treasury Inflation Protected Securities (TIPS) and UK Index Linked Gilts. This type of fixed income is adjusted to a Consumer Price Index (in the US this is the CPI-U for urban consumers), and then a real yield is applied to the adjusted principal. This means that these bonds are guaranteed to outperform the inflation rate (unless the government defaults on the bond). This allows investors of all sizes to not lose the purchasing power of their money due to inflation, which can be very uncertain at times. For example, assuming 3.88% inflation over the course of 1 year (just about the 56 year average inflation rate, through most of 2006), and a real yield of 2.61% (the fixed US Treasury real yield on October 19, 2006, for a 5 yr TIPS), the adjusted principal of the fixed income would rise from 100 to 103.88 and then the real yield would be applied to the adjusted principal, meaning 103.88 x 1.0261, which equals 106.5913; giving a total return of 6.5913%. TIPS moderately outperform conventional US Treasuries, which yielded just 5.05% for a 1 yr bill on October 19, 2006.

Derivatives

Fixed income derivatives include interest rate derivatives and credit derivatives. Often inflation derivatives are also included into this definition. There is a wide range of fixed income derivative products: options, swaps, futures contracts as well as forward contracts. The most widely traded kinds are:

• Credit default swaps
• Interest rate swaps
• Inflation swaps
• Bond futures on 2/10/30-year government bonds
• Interest rate futures on 90-day interbank interest rates
• Forward rate agreements

Risks

Fixed income securities from any entity have risks that may include but are not limited to:

• inflationary risk – that the buying power of the principal will decline during the term of the security
• interest rate risk – that overall interest rates will change from the levels extant when the security is sold, causing an opportunity cost
• currency risk – that exchange rates with other currencies will change during the security's term, causing loss of buying power in other countries
• default risk – that the issuer will be unable to pay the scheduled interest payments due to financial hardship
• repayment of principal risk – that the issuer will be unable to repay the principal due to financial hardship
• reinvestment risk – that the purchaser will be unable to purchase another security of similar return upon the expiration of the current security
• liquidity risk – that the buyer will require the principal funds for another purpose on short notice, prior to the expiration of the security, and be unable to exchange the security for cash in the required time period without loss of fair value
• maturity risk – this is another name for interest rate risk
• streaming income payment risk
• duration risk
• convexity risk
• credit quality risk
• political risk – that governmental actions will cause the owner to lose the benefits of the security
• tax adjustment risk
• market risk – the risk of market-wide changes affecting the value of the security
• climate risk
• event risk – the risk that externalities will cause the owner to lose the benefits of the security

See also

• Fixed income analysis

External links

• UK Debt Management Office