Fixed income",

What Is Fixed Income?

Fixed income refers to an investment asset class that provides investors with a predictable stream of payments, typically in the form of regular interest payments, and the return of principal at a predetermined maturity date. These securities, such as bonds, are essentially loans made by an investor to a borrower, which could be a corporation, government, or other entity. The "fixed" aspect derives from the generally unchanging nature of these payments, although certain types of fixed income securities can have variable interest rates. Investors typically seek fixed income for stability, capital preservation, and a steady stream of revenue within their portfolio diversification strategies.

History and Origin

The concept of lending money for a fixed return dates back to ancient civilizations, with records indicating the existence of debt contracts in Mesopotamia around 2400 BC, often related to grain payments²⁴. However, the modern form of fixed income, characterized by transferable government debt, emerged much later. The first recorded sovereign bond was issued by the newly formed Bank of England in 1693 to fund conflict with France²³.

In the United States, the issuance of sovereign debt began to finance significant national endeavors. The U.S. government first issued Treasury bonds to fund the American Revolutionary War²². A pivotal development in the U.S. fixed income market was the widespread sale of war bonds, such as Series E bonds, during World War I and World War II, which broadly introduced government debt as a popular investment for the public²⁰, ²¹. The design of U.S. Treasury bonds was initially determined by Congress, but starting in 1920, this responsibility was delegated to the Treasury Department, leading to the development of a more structured and actively traded market for fixed income securities¹⁹.

Key Takeaways

• Fixed income securities offer investors a regular, predetermined stream of payments, often interest, and the return of principal.
• They are generally considered less volatile than equities and are valued for capital preservation and income generation.
• The fixed income market encompasses a wide range of debt instruments issued by governments, corporations, and other entities.
• Key factors influencing fixed income prices and yields include interest rates, credit risk, and inflation.
• Fixed income plays a crucial role in asset allocation strategies, providing stability and diversification benefits to investment portfolios.

Formula and Calculation

The most common way to value a simple fixed income bond is by calculating its present value (PV) of future cash flows, which consist of periodic coupon rate payments and the final principal repayment at maturity.

The formula for the present value of a bond is:

$PV = \sum_{t=1}^{n} \frac{C}{(1+r)^t} + \frac{F}{(1+r)^n}$

Where:

• (PV) = Present value of the bond (its current market price)
• (C) = Periodic coupon payment
• (r) = Market interest rate or required yield to maturity per period
• (n) = Number of periods until maturity
• (F) = Face value (par value) of the bond

For example, if a bond pays interest semi-annually, (C) would be the semi-annual coupon payment, (r) would be the semi-annual market interest rate, and (n) would be the total number of semi-annual periods. Other metrics like duration are used to measure a bond's price sensitivity to changes in interest rates.

Interpreting Fixed Income

Interpreting fixed income involves understanding the interplay of several factors that influence its value and attractiveness. The primary interpretation revolves around the yield an investor receives relative to the risk taken. A higher yield typically compensates for greater perceived risks, such as increased default risk or longer maturities, which expose investors to more interest rate risk.

When market interest rates rise, newly issued fixed income securities offer higher coupon payments, making existing bonds with lower coupon rates less attractive. This dynamic causes the market prices of existing bonds to fall, leading to an inverse relationship between interest rates and bond prices. Conversely, when interest rates fall, existing fixed income securities with higher coupon rates become more valuable, and their market prices increase. Investors assess whether the yield provided by a fixed income security adequately compensates them for the prevailing market interest rates, the issuer's creditworthiness, and the bond's term to maturity.

Hypothetical Example

Consider an investor purchasing a newly issued corporate bond with the following characteristics:

• Face Value (F): $1,000
• Coupon Rate: 5% per annum, paid semi-annually
• Maturity: 10 years

This bond will pay a coupon of (5% of $1,000) / 2 = $25 every six months for 10 years (20 periods). At the end of 10 years, the investor will also receive the $1,000 face value.

If the prevailing market interest rates for similar bonds remain at 5%, the bond's market price would be approximately $1,000. However, suppose market interest rates for comparable bonds drop to 4% shortly after issuance. The existing 5% bond suddenly becomes more attractive because it offers a higher coupon payment than new bonds. As a result, its market price would rise above $1,000. Conversely, if market interest rates increase to 6%, the 5% bond becomes less attractive, and its market price would fall below $1,000. This example illustrates how the fixed payments of fixed income securities interact with changing market conditions to affect their value.

Practical Applications

Fixed income securities are foundational components in various aspects of the financial world:

• Investment Portfolios: Individual and institutional investors use fixed income for income generation, capital preservation, and portfolio diversification. They are often a core holding for retirees or those seeking stable returns.
• Monetary Policy: Central banks, such as the Federal Reserve, use the buying and selling of government bonds in open market operations as a primary tool to influence interest rates and control the money supply¹⁷, ¹⁸. Changes in monetary policy directly impact fixed income yields and prices.
• Corporate and Government Financing: Governments issue Treasury bonds and municipal bonds to finance public projects and government operations, while corporations issue corporate bonds to fund their business expansion, operations, and acquisitions¹⁶.
• Risk Management: Fixed income can serve as a hedge against equity market volatility. During periods of economic uncertainty, investors often gravitate towards the stability of fixed income, especially highly-rated government bonds, as a "safe haven" asset.
• Market Transparency and Regulation: In the U.S., the Financial Industry Regulatory Authority (FINRA) operates the Trade Reporting and Compliance Engine (TRACE) system, which mandates the reporting of over-the-counter transactions in eligible fixed income securities. This initiative significantly enhances transparency in the bond market by providing public access to trade data¹⁴, ¹⁵.

Limitations and Criticisms

Despite their benefits, fixed income investments are not without limitations and criticisms. One primary concern is interest rate risk. Since bond prices move inversely to interest rates, a sudden rise in rates can lead to a significant decrease in the market value of existing fixed income holdings. This risk is particularly pronounced for bonds with longer duration.

Another significant limitation is inflation risk. While fixed income offers predictable payments, the purchasing power of those fixed payments can erode over time if inflation rises unexpectedly. This means the real return on a fixed income investment might be lower than anticipated, or even negative, especially for long-term bonds.

Default risk, also known as credit risk, is another consideration. Although government bonds from stable economies carry minimal default risk, corporate and municipal bonds carry the risk that the issuer may be unable to make its promised interest or principal payments. This risk varies greatly depending on the issuer's financial health and credit rating.

Furthermore, the liquidity of certain fixed income markets can be lower than that of equity markets. While highly traded government bonds are very liquid, some less common corporate bonds or municipal bonds may be difficult to sell quickly without affecting the price, particularly for large blocks. In times of market stress, even typically liquid fixed income funds can experience significant outflows and liquidity challenges, as seen during the COVID-19 market turmoil in March 2020, where funds faced intense withdrawals and deterioration in the market liquidity of their holdings¹³.

Fixed Income vs. Equities

Fixed income and equities represent two fundamental but distinct investment asset classes, often forming the core of an investor's asset allocation strategy. The primary distinction lies in their nature: fixed income securities represent debt, while equities represent ownership.

Investors often seek fixed income for stability, capital preservation, and consistent income, whereas equities are favored for long-term growth potential and capital appreciation. The blend of these two asset classes forms the basis of many diversified portfolios, aiming to balance risk and return objectives.

FAQs

What is the primary goal of investing in fixed income?

The primary goal of investing in fixed income is typically to generate a steady stream of income and preserve capital. Investors often use fixed income to reduce overall portfolio diversification risk and provide a predictable cash flow, which can be particularly appealing for retirees or those with specific income needs.

How do interest rates affect fixed income investments?

Interest rates have an inverse relationship with the prices of existing fixed income securities. When market interest rates rise, the market value of existing bonds with lower fixed coupon rates typically falls, as new bonds offer more attractive yields. Conversely, when interest rates fall, existing fixed income securities become more valuable, and their prices tend to rise.

Are all fixed income investments risk-free?

No, not all fixed income investments are risk-free. While some, like Treasury bonds issued by stable governments, are considered to have minimal default risk, most fixed income securities carry various risks. These include interest rate risk, credit risk (the risk that the issuer defaults on payments), and inflation risk (the risk that rising prices erode the purchasing power of fixed payments).¹, ², ³⁴, ⁵, ⁶, ⁷⁸, ⁹, ¹⁰¹¹, ¹²