What is Fixed Income?
Bonds can offer diversification benefits because they often perform in the opposite direction to shares. Bond investments, therefore, help to lower the risk level within a diversified portfolio.
What are bonds?
One way a government or a company can obtain the money they need to fund their projects or initiatives is to sell bonds.
In other words, a bond is a loan sold or issued by the borrower (issuer) and purchased by the lender (investor). The borrower in turn makes two key promises to the lender:
- To repay capital at maturity – the loan will be repaid on a predetermined date.
- To pay regular interest payments at a rate known as the coupon rate. This forms the interest on the borrowed amount paid to the investor during the life of the loan.
Bond maturities range from 1 year to 30 years and are frequently categorised as:
- Short-term bonds: Maturing in less than 5 Years.
- Medium-term bonds: Maturing in 5 – 10 years.
- Long-term bonds: Maturing in more than 10 years.
What are the typical risks involved in Fixed Income Investing?
- Interest Rate Risk: Bond prices and interest rates have an inverse relationship. When interest rates rise, bond prices fall, and vice versa.
- Credit Risk: The risk that the issuer may default on interest payments or fail to repay the principal.
- Inflation Risk: If inflation exceeds the interest earned on fixed income securities, the real return may be diminished.
- Liquidity Risk: Some fixed income securities may lack liquidity, making it challenging to sell them at desired prices.
Conclusion: Fixed income is an asset class for all types of investors seeking a balance of income and stability in their portfolios. Understanding the types, benefits, and risks associated with fixed income securities is essential for making informed investment decisions. As with any investment, it’s crucial to conduct thorough research or consult with financial professionals to align your fixed income strategy with your financial goals and risk tolerance.
| Key Term | Description |
|---|---|
| Coupon Rate | The coupon rate is the annual interest rate that the issuer pays to the bondholder. It is expressed as a percentage of the bond’s face value (or par value). For example, a bond with a 5% coupon rate and a $1,000 par value pays $50 in interest annually ($1,000 * 5%). |
| Par Value | Par value is the nominal or face value of a bond, representing the amount the bondholder will receive at maturity. It is typically set at $1,000 per bond, but it can vary. The market price of a bond may be higher or lower than its par value. |
| Maturity date | The maturity date is the date when the issuer must repay the principal amount to the bondholder. Bonds can have various maturity periods, ranging from short-term (less than one year) to long-term (over 30 years). The choice of maturity depends on the issuer’s needs and the investor’s preferences. |
| Yield | Yield is a measure of the return on investment for a bond and is expressed as a percentage. There are different types of yields, such as the current yield (annual interest divided by the bond’s market price) and yield to maturity (the total return anticipated on a bond if held until it matures). |
| Callable / Non-Callable | Callable bonds give the issuer the option to redeem the bond before its maturity date. This provides flexibility but may result in a lower yield for the investor. Non-callable bonds, on the other hand, cannot be redeemed before maturity, offering more stability to the bondholder. |
| Credit Rating | Credit rating assesses the creditworthiness of the issuer and indicates the likelihood of timely repayment. Rating agencies, such as Moody’s and Standard & Poor’s, assign letter grades (e.g., AAA, AA, A, BBB) to bonds, with higher ratings indicating lower credit risk. |