Fixed income
Encyclopedia
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 bond
s in their own currency and sovereign bonds in foreign currencies. Local governments issue municipal bond
s 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 stock
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 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 stock
s. 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.
s set by central bank
s 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.
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. 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.
s and credit derivative
s. Often inflation derivatives are also included into this definition. There is a wide range of fixed income derivative products: option
s, swap
s, futures contract
s as well as forward contract
s. The most widely traded kinds are:
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
that is not equity
Equity (finance)
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
, 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
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
once a month, you have been issued a fixed-income security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
. Governments issue government bond
Government bond
A government bond is a bond issued by a national government denominated in the country's own currency. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or country...
s in their own currency and sovereign bonds in foreign currencies. Local governments issue municipal bond
Municipal bond
A municipal bond is a bond issued by a city or other local government, or their agencies. Potential issuers of municipal bonds includes cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and seaports, and any...
s to finance themselves. Debt issued by government-backed agencies is called an agency bond. Companies can issue a corporate bond
Corporate bond
A corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date...
or get money from a bank through a corporate loan ("preferred stock
Preferred stock
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument...
" 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
Asset-backed security
An asset-backed security is a security whose value and income payments are derived from and collateralized by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually...
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 stock
Preferred stock
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument...
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 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 stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
s. 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
Ownership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
in the company (stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
), or the company can give a promise to pay regular interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
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
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
, 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 issuerIssuerIssuer is a legal entity that develops, registers and sells securities for the purpose of financing its operations.Issuers may be domestic or foreign governments, corporations or investment trusts...
is the entity (company or govt.) who borrows an amount of money (issuing the bond) and pays the interest. - The principalDebtA debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
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 couponCoupon (bond)A coupon payment on a bond is a periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. Coupons are normally described in terms of the coupon rate, which is calculated by adding the total amount of coupons paid per year and...
(of a bond) is the interest that the issuer must pay. - The maturityMaturity (finance)In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal is due to be paid....
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 indentureIndentureAn indenture is a legal contract reflecting a debt or purchase obligation, specifically referring to two types of practices: in historical usage, an indentured servant status, and in modern usage, an instrument used for commercial debt or real estate transaction.-Historical usage:An indenture is a...
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
Interest rates change over time, based on a variety of factors, particularly base rateBase rate
In probability and statistics, base rate generally refers to the class probabilities unconditioned on featural evidence, frequently also known as prior probabilities...
s set by central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
s such as the US Federal Reserve, UK Bank of England
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, it is the second oldest central bank in the world...
, and Euro Zone ECB
ECB
ECB is an abbreviation for:*European Central Bank, the central bank for the Eurozone of the European Union* East Coast Bays, a suburb of North Shore City, New Zealand**East Coast Bays AFC, a football team from East Coast Bays...
. 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 bondInflation-indexed bond
Inflation-indexed bonds are bonds where the principal is indexed to inflation. They are thus designed to cut out the inflation risk of an investment. The first known inflation-indexed bond was issued by the Massachusetts Bay Company in 1780...
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. This type of fixed income is adjusted to a Consumer Price Index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
(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 derivativeInterest rate derivative
An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate...
s and credit derivative
Credit derivative
In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself...
s. Often inflation derivatives are also included into this definition. There is a wide range of fixed income derivative products: option
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
s, swap
Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
s, futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s as well as forward contract
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 today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
s. The most widely traded kinds are:
- Credit default swapCredit default swapA credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
s - Interest rate swapInterest rate swapAn interest rate swap is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate or from one floating rate to another...
s - Inflation swaps
- Bond futures on 2/10/30-year government bonds
- Interest rate futureInterest rate futureAn interest rate futures is a financial derivative with an interest-bearing instrument as the underlying asset.Examples include Treasury-bill futures, Treasury-bond futures and Eurodollar futures....
s on 90-day interbank interest rates - Forward rate agreementForward rate agreementIn finance, a forward rate agreement is a forward contract, an over-the-counter contract between parties that determines the rate of interest, or the currency exchange rate, to be paid or received on an obligation beginning at a future start date. The contract will determine the rates to be used...
s
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 riskLiquidity riskIn finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of 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 riskClimate riskClimate risk means a risk resulting from climate change and affecting natural and human systems and regions.In the course of increasing global temperature and extreme weather phenomena...
- event risk – the risk that externalities will cause the owner to lose the benefits of the security