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Fixed income refers to any type of
investment Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance, the purpose of investing is ...
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 In finance and economics, interest is payment from a debtor, borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is ...
at a fixed rate once a year and repay the principal amount on maturity. Fixed-income
securities A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
— 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 In finance and economics, interest is payment from a debtor, borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is ...
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 bond Daily inflation-indexed bonds (also known as inflation-linked bonds or colloquially as linkers) are Bond (finance), bonds where the principal is indexed to inflation or deflation on a daily basis. They are thus designed to hedge the inflation ris ...
s, 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 eit ...
, 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 debt ...
. 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 inst ...
s or
pension A pension (, from Latin ''pensiō'', "payment") is a fund into which a sum of money is added during an employee's employment years and from which payments are drawn to support the person's retirement from work in the form of periodic payments ...
s 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 Disposable income is total personal income minus current income taxes. In national accounts definitions, personal income minus income tax, personal current taxes equals disposable personal income. Subtracting personal outlays (which includes ...
or have little financial freedom to make large or discretionary expenditures.


Types of borrowers

Governments issue
government bond A government bond or sovereign bond is a form of bond issued by a government A government is the system or group of people governing an organized community, generally a state. In the case of its broad associative definition, go ...
s in their own currency and
sovereign bond A government bond or sovereign bond is a form of bond issued by a government A government is the system or group of people governing an organized community, generally a state. In the case of its broad associative definition, go ...
s 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 (finance), bond issued by a corporation in order to raise financing for a variety of reasons such as to ongoing operations, Mergers and acquisitions, M&A, or to expand business. The term is usually applied to Financia ...
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 inst ...
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 Issuer is a legal entity that develops, registers, and sells Security (finance), securities for the purpose of financing its operations. Issuers may be governments, corporations, or investment trusts. Issuers are legally responsible for the obli ...
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 discounts and allowances, discount or rebate (marketing), rebate when purchasing a product (business), product. Customarily, coupons are issued by manufacturers ...
(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 An indenture is a legal contract that reflects or covers a debt or purchase obligation. It specifically refers to two types of practices: in historical usage, an indentured servant status, and in modern usage, it is an instrument used for commercia ...
, 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 An institutional investor is an entity which pools money to purchase Security (finance), securities, real property, and other investment assets or originate loans. Institutional investors include commercial banks, central banks, credit unions, ...
, 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 Probability is the branch of mathematics concerning numerical descriptions of how likely an Event (probability theory), event is to occur, or how likely it is that a proposition is true. The probability of an event is a nu ...
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 bank, commercial banking system. In contrast to a commercial 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 a ...
, 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 Kingdom of England, English Government's banker, and still one of the bankers fo ...
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.).


Inflation-linked bonds

There are also
inflation-indexed bond Daily inflation-indexed bonds (also known as inflation-linked bonds or colloquially as linkers) are Bond (finance), bonds where the principal is indexed to inflation or deflation on a daily basis. They are thus designed to hedge the inflation ris ...
s—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. 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 Goods, consumer goods and Service (economics), services purchased by households. Changes in measured CPI track changes in prices over time. Ove ...
(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.


Derivatives

Fixed income derivatives include
interest rate derivative In finance, an interest rate derivative (IRD) is a derivative (finance), derivative whose payments are determined through calculation techniques where the underlying benchmark product is an interest rate, or set of different interest rates. There a ...
s 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 contract In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpti ...
s as well as
forward contract In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumpt ...
s. The most widely traded kinds are: *
Credit default swap A credit default swap (CDS) is a Swap (finance), financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt Default (finance), default (by the debtor) or other credit event. That is, the seller of the ...
s *
Interest rate swap In finance, an interest rate swap (finance), swap (IRS) is an interest rate derivative, interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a Interest_rate_derivative#Linear_and_non-linear ...
s * Inflation swaps * Bond futures on 2/10/30-year government bonds *
Interest rate future An interest rate future is a financial derivative In finance, a derivative is a contract that ''derives'' its value from the performance of an underlying entity. This underlying entity can be an asset, Index fund, index, or interest rate, and ...
s on 90-day interbank interest rates *
Forward rate agreement In finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of Production (economics), production, Distribution (economics), distribution, and Consumption ...
s


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 – 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 Liquidity risk is a financial risk that for a certain period of time a given financial asset, Security (finance), security or commodity cannot be traded quickly enough in the market without impacting the market price. Types Market liquidity – A ...
– 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


See also

*
Fixed income analysis Fixed income analysis is the process of determining the value of a debt security based on an assessment of its risk profile, which can include interest rate risk, risk of the issuer failing to repay the debt, market supply and demand for the sec ...


References


External links


UK Debt Management OfficeFixed Income
{{Investment management * th:ตราสารหนี้