Fixed income refers to any type of

investment Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...

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 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 distinct f ...

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 Stocks (also capital stock, or sometimes interchangeably, shares) consist of all the shares by which ownership of a corporation or company is divided. A single share of the stock means fractional ownership of the corporation in proportion t ...

(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

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 bonds where the principal is indexed to inflation or deflation on a daily basis. They are thus designed to hedge the inflation risk of a bond. T ...

s, variable-interest rate notes, and the like. If an issuer misses a payment on fixed income security, the issuer is in default, 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 deb ...

. 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 any combination of (1) 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 ins ...

s or (2)

pension A pension (; ) is a fund into which amounts are paid regularly during an individual's working career, and from which periodic payments are made to support the person's retirement from work. A pension may be either a " defined benefit plan", wh ...

s that guarantee a fixed income ( defined benefit as contrasted with

defined contribution A defined contribution (DC) plan is a type of retirement plan in which the employer, employee or both make contributions on a regular basis. Individual accounts are set up for participants and benefits are based on the amounts credited to these a ...

). When pensioners or retirees are dependent on their pension (whether a private-sector one, a public-sector one, or both) 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 taxes on income. In national accounting, personal income minus personal current taxes equals disposable personal income or household disposable income. Subtracting personal outlays ( ...

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 (finance), bond issued by a government to support government spending, public spending. It generally includes a commitment to pay periodic interest, called Coupon (finance), coupon payments' ...

s in their own currency and

sovereign bond A government bond or sovereign bond is a form of bond issued by a government to support public spending. It generally includes a commitment to pay periodic interest, called coupon payments'','' and to repay the face value on the maturity da ...

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 Agency debt, also known as an agency bond, agency loan, agency security, or "Agencies", is a security, usually a bond, issued by a United States government-sponsored enterprise or federal budget agency. The offerings of these agencies are backed ...

. 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, mergers & acquisitions, or to expand business. It is a longer-term debt instrument indicating that a corpo ...

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 ins ...

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 securities for the purpose of financing its operations. Issuers may be governments, corporations, or investment trusts. Issuers are legally responsible for the obligations of the issue ...

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 ...

(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 an agreement between two parties. Although the term is most familiarly used to refer to a labor contract between an employer and a laborer with an indentured servant status, historically indentures we ...

, 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 that 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, s ...

, 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 The yield to maturity (YTM), book yield or redemption yield of a fixed-interest security is an estimate of the total rate of return anticipated to be earned by an investor who buys it at a given market price, holds it to maturity, and receives ...

. 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). It is the proportion of individuals in a population who have a certain characte ...

s set by

central bank A central bank, reserve bank, national bank, or monetary authority is an institution that manages the monetary policy of a country or monetary union. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the mo ...

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. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of ...

, 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 debt manager, and still one ...

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

s—fixed-income securities linked to a specific price index. The most common examples are US

Treasury Inflation Protected Securities United States Treasury securities, also called Treasuries or Treasurys, are government debt instruments issued by the United States Department of the Treasury to finance government spending as a supplement to taxation. Since 2012, the U.S. ...

(TIPS) and UK Index Linked

Gilts Gilt-edged securities, also referred to as gilts, are bonds issued by the UK Government. The term is of British origin, and referred to the debt securities issued by the Bank of England on behalf of His Majesty's Treasury, whose paper certific ...

. 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 statistical estimate of the level of prices of goods and services bought for consumption purposes by households. It is calculated as the weighted average price of a market basket of Goods, consumer goods and ...

(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 whose payments are determined through calculation techniques where the underlying benchmark product is an interest rate, or set of different interest rates. There are a multitude of dif ...

s and

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 derivative In finance, inflation derivative (or inflation-indexed derivatives) refers to an over-the-counter (finance), over-the-counter and exchange-traded derivative (finance), derivative that is used to transfer inflation risk from one counterparty to anot ...

s are also included into this definition. There is a wide range of fixed income derivative products: options, swaps,

futures contract In finance, a futures contract (sometimes called 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 item tr ...

s as well as

forward contract In finance, a forward contract, or simply a forward, is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on in the contract, making it a type of derivative instrument.John C Hu ...

s. The most widely traded kinds are: * Credit default swaps *

Interest rate swap In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with ...

s *

Inflation swap An inflation swap is an agreement between two counterparty, 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 future An interest rate future is a futures contract (a financial derivative) with an interest-bearing instrument as the underlying asset. It is a particular type of interest rate derivative. Examples include Treasury-bill futures, Treasury-bond future ...

s on 90-day interbank interest rates *

Forward rate agreement In finance, a forward rate agreement (FRA) is an interest rate derivative (IRD). In particular, it is a linear IRD with strong associations with interest rate swaps (IRSs). General description A forward rate agreement's (FRA's) effective desc ...

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 Monetary inflation is a sustained increase in the money supply of a country (or currency area). Depending on many factors, especially public expectations, the fundamental state and development of the economy, and the transmission mechanism, it ...

– that the buying power of the principal and interest payments will decline during the term of the security *

interest rate risk Interest rate risk is the risk that arises for bond owners from fluctuating interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The ...

– that overall interest rates will change from the levels available when the security is sold, causing an

opportunity cost In microeconomic theory, the opportunity cost of a choice is the value of the best alternative forgone where, given limited resources, a choice needs to be made between several mutually exclusive alternatives. Assuming the best choice is made, ...

currency risk A currency is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins. A more general definition is that a currency is a ''system of money'' in common use within a specific environ ...

– that exchange rates with other currencies will change during the security's term, causing loss of buying power in other countries *

default risk Credit risk is the chance that a borrower does not repay a loan or fulfill a loan obligation. For lenders the risk includes late or lost interest and principal payment, leading to disrupted cash flows and increased collection costs. The loss m ...

– 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 or commodity cannot be traded quickly enough in the market without impacting the market price. Types Market liquidity – An asset cannot be ...

– 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 * call risk - that the issuer will redeem or call back a fixed-income security before its maturity date, which can result in the investor receiving the principal earlier than expected and potentially at a lower interest rate or price * duration risk *

convexity risk In mathematical finance, convexity refers to non-linearities in a financial model. In other words, if the price of an underlying variable changes, the price of an output does not change linearly, but depends on the second derivative (or, loosely sp ...

* 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

References

External links

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