Fixed income refers to any type of investment that yields a regular (or fixed) return.
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 bonds in their own currency and sovereign bonds in foreign currencies. Local governments issue municipal bonds 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" is also sometimes considered to be fixed income). 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 stocks 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 variable return securities such as stocks. 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 only give money to the company 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 or bank loan) or (preferred stock).
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 issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and pays the interest.
- The principal (of a bond) is the amount that the issuer borrows.
- The coupon (of a bond) is the interest that the issuer must pay.
- 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 is the contract that states all of the terms of the bond.
Investors
People who invest 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 rates set by central banks such as the US Federal Reserve. For example, if a company wants to raise $1 million and not a lot of people in the market have free cash to lend, the company will have to offer a high rate of interest (coupon) to get people to buy their bond. If there are a lot of people in the market trying to get a return on their money, the company can offer a lower coupon.
To complicate matters further, fixed income securities are actually traded on the open market, just like stocks. To understand this, first realize that bonds are usually created in round face values, for example $100,000. If the current yield (interest rate) of newly issued similar bonds is 6% per year, and you are buying a bond with a coupon rate below 6%, then you can get the bond at a discount (below face value of $100,000), which brings your rate of return on that bond to 6%. Similarly, if the coupon rate of the bond you are buying is greater than 6% you will have to pay a premium for the bond to bring the rate of return down to 6%.
Inflation-linked bonds
There are also inflation-indexed bonds, 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 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 derivatives and credit derivatives. Often inflation derivatives are also included into this definition. There is a wide gamut of fixed income derivative products: options, swaps, futures contracts as well as forward contracts. The most widely traded kinds are
Risks
All fixed income securities from any entity have risks including but not limited to:
- inflationary risk
- interest rate risk
- currency risk
- default risk
- repayment of principal risk
- reinvestment risk
- liquidity risk
- maturity risk
- streaming income payment risk
- duration risk
- convexity risk
- credit quality risk
- political risk
- tax adjustment risk
- market risk
- climate risk
- event risk
