Fixed income refers to any type of investment under which the borrower or issuer is obliged to make payments of a fixed amount on a fixed schedule. For example, the borrower may have to pay interest at a fixed rate once a year and repay the principal amount on maturity. Fixed-income securities — more commonly known as bonds — can be contrasted with equity securities – often referred to as stocks and shares – that create no obligation to pay dividends or any other form of income. Bonds carry a level of legal protections for investors that equity securities do not — in the event of a bankruptcy, bond holders would be repaid after liquidation of assets, whereas shareholders with stock often receive nothing.
For a company to grow its business, it often must raise money – for example, to finance an acquisition; buy equipment or land, or invest in new product development. The terms on which investors will finance the company will depend on the risk profile of the company. The company can give up equity by issuing stock or can promise to pay regular interest and repay the principal on the loan (bonds or bank loans). Fixed-income securities also trade differently than equities. Whereas equities, such as common stock, trade on exchanges or other established trading venues, many fixed-income securities trade over-the-counter on a principal basis.
The term "fixed" in "fixed income" refers to both the schedule of obligatory payments and the amount. "Fixed income securities" can be distinguished from inflation-indexed bonds, variable-interest rate notes, and the like. If an issuer misses a payment on fixed income security, the issuer is in
default
Default may refer to:
Law
* Default (law), the failure to do something required by law
** Default (finance), failure to satisfy the terms of a loan obligation or failure to pay back a loan
** Default judgment, a binding judgment in favor of ei ...
, and depending on the relevant law and the structure of the security, the payees may be able to force the issuer into
bankruptcy
Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debto ...
. 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.
The term "fixed income" is also applied to a person's income that does not vary materially over time. This can include income derived from fixed-income investments such as bonds and
preferred stock
Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt in ...
s 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 imply that they have relatively limited discretionary income or have little financial freedom to make large or discretionary expenditures.
Types of borrowers
Governments issue government bonds in their own currency and sovereign bonds in foreign currencies. State and local governments issue
municipal bond
A municipal bond, commonly known as a muni, is a bond issued by state or local governments, or entities they create such as authorities and special districts. In the United States, interest income received by holders of municipal bonds is often, ...
s to finance projects or other major spending initiatives. Debt issued by government-backed agencies is called an agency bond. Companies can issue a
corporate bond
A corporate bond is a bond issued by a corporation in order to raise financing for a variety of reasons such as to ongoing operations, M&A, or to expand business. The term is usually applied to longer-term debt instruments, with maturity of ...
or obtain money from a bank through a corporate loan.
Preferred stock
Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt in ...
s share some of the characteristics of fixed interest bonds. 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 over-the-counter just like corporate and government bonds.
Terminology
Some of the terminology used in connection with these investments is:
*The issuer is the entity (company or government) who borrows the money by issuing the bond, and is due to pay interest and repay capital in due course.
*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
In marketing, a coupon is a ticket or document that can be redeemed for a financial discount or rebate when purchasing a product.
Customarily, coupons are issued by manufacturers of consumer packaged goods
or by retailers, to be used in r ...
(of a bond) is the annual interest that the issuer must pay, expressed as a percentage of the principal.
*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, in some cases, 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 like gratuity, 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. The major investors in fixed-income securities are institutional investors, such as pension plans, mutual funds, hedge funds, sovereign wealth funds, endowments, insurance companies and others.
Pricing factors
The main number which is used to assess the value of the bond is the gross redemption yield. This is defined such that if all future interest and principal repayments are discounted back to the present, at an interest rate equal to the gross redemption yield (gross means pre-tax), then the discounted value is equal to the current market price of the bond (or the initial issue price if the bond is just being launched). 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 denominated in US dollars has a gross redemption yield of 5% per annum and 30 year US Treasury Bonds have a gross redemption yield of 3% per annum (referred to as the risk free yield), the credit spread is 2% per annum (sometimes quoted as 200 basis points). The credit spread reflects the risk of default. Risk free interest rates are determined by market forces and vary over time, based on a variety of factors, such as current short-term interest rates, e.g.
base rate
In probability and statistics, the base rate (also known as prior probabilities) is the class of probabilities unconditional on "featural evidence" (likelihoods).
For example, if 1% of the population were medical professionals, and remaining ...
s set by
central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...
s such as the US
Federal Reserve
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after ...
, the
Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694 to act as the English Government's banker, and still one of the bankers for the Government o ...
in the UK, and the Euro Zone ECB. If the coupon on the bond is lower than the yield, then its price will be below the par value, and vice versa.
In buying a bond, one is 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 who are constrained in the investments they make. Insurance companies and pension funds usually have long term liabilities that they wish to hedge, which requires low risk, predictable cash flows, such as long dated government bonds.
Some fixed-income securities, such as mortgage-backed securities, have unique characteristics, such as prepayments, which impact their pricing.Lemke and Lins, ''Mortgage-Backed Securities'', § 5:12 (Thomson West, 2014–2015 ed.).
Gilts
Gilt-edged securities are bonds issued by the UK Government. The term is of British origin, and then referred to the debt securities issued by the Bank of England on behalf of His Majesty's Treasury, whose paper certificates had a gilt (or gilde ...
. The interest and principal repayments under this type of bond are adjusted in line with a
Consumer Price Index
A consumer price index (CPI) is a price index, the price of a weighted average market basket of consumer goods and services purchased by households. Changes in measured CPI track changes in prices over time.
Overview
A CPI is a statistic ...
(in the US this is the CPI-U for urban consumers). This means that these bonds are guaranteed to outperform the inflation rate (unless (a) the market price has increased so that the "real" yield is negative, which is the case in 2012 for many such UK bonds, or (b) the government or other issuer defaults on the bond). This allows investors of all types to preserve the purchasing power of their money even at times of high inflation. For example, assuming 3.88% inflation over the course of one 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 one-year bill on October 19, 2006.
credit derivative
In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the ''credit risk''"The Economist ''Passing on the risks'' 2 November 1996 or the risk of an event of default of a corp ...
s. Often inflation derivatives are also included into this definition. There is a wide range of fixed income derivative products:
options
Option or Options may refer to:
Computing
*Option key, a key on Apple computer keyboards
*Option type, a polymorphic data type in programming languages
*Command-line option, an optional parameter to a command
*OPTIONS, an HTTP request method
...
futures contract
In finance, a futures contract (sometimes called a futures) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset ...
s as well as forward contracts. The most widely traded kinds are:
*
Credit default swap
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against som ...
Inflation swap An inflation swap is an agreement between two counterparties to swap fixed rate payments on a notional principal amount for floating rate payments linked to an inflation index, such as the consumer price index.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 have risks that may include but are not limited to the following, many of which are synonymous, mutually exclusive, or related:
* inflation risk – that the buying power of the principal and interest payments will decline during the term of the security
* interest rate risk – that overall interest rates will change from the levels available 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
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased c ...
– that the issuer will be unable to pay the scheduled interest payments or principal repayment due to financial hardship or otherwise
* 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
* 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
* event risk – the risk that externalities will cause the owner to lose the benefits of the security