Demystifying fixed income
A fixed income investment is a simple interest only loan. It may be made to a government, semi-government authority or company; as such, fixed income investments are often referred to as ‘debt’ investments. An investor agrees to purchase a fixed income asset from an issuer in exchange for interest payments (or coupons) over time and repayment of the principal at maturity. The investor acts as a lender and the issuer acts as a borrower. So, investors in fixed income are simply lenders of capital.
When you buy a fixed income investment, you are lending a certain amount of money for a specific amount of time. You receive scheduled interest payments of fixed amounts at fixed times - hence the term ‘fixed income’.
At end of the term, you - or the fixed income fund you’re invested in - get your money back; if the security was bought at issue, the full value is returned. If the security was purchased during its term, the face value is returned upon maturity.
This interaction between the issuer and investor is illustrated in figure one.
Demystifying fixed income
Fixed income has specific terminology - or jargon - you may encounter. In fact, we’ve already used it in the introduction to this article. It can seem confusing at first glance, as it isn’t terminology investors come across every day - and rarely features in the finance or sharemarket section at the end of the news each evening.
The most commonly used terms in reference to fixed income are defined in figure two.
Did you know...
When referring to different types of issuers in credit and fixed income in Australia, 'semi government' simply refers to the various state and territory governments. When these authorities or state governments issue bonds, they will often carry a slightly higher credit risk over similar Commonwealth Government bonds. They will usually feature different credit ratings from one another too – designed to reflect the creditworthiness of each individual state government.
Fixed income features
Fixed income securities have a range of features. Although a broad range of securities get put in the fixed income bucket, it’s important for investors to understand the differences that may exist.
How fixed income works
The best way to understand a fixed income investment is to examine it from issue to maturity.
Fixed income securities are originated in the primary market, from where they are sold to investors. Because the minimum transaction in the primary market is usually large, most fixed income issues are bought by wholesale investors such as fund managers.
Using a very simplistic example, if an investor bought a 10-year government bond at issue for $100, received an annual coupon of 5%, and held it to maturity, the cashflow would look like this. The investor would receive coupon payment/s each year, totalling 5% and, at maturity, the principal – or loan – is repaid.
Although some investors buy and hold fixed income securities from issue to maturity, they are commonly traded in the secondary market. A number of factors - such as central bank policy, interest rate moves and the economic environment - can impact a security’s face value and yield once trading in the secondary market commences.
It’s important to note that fixed income securities may trade at a premium or a discount to their face value.
If you (or the manager of a fixed interest fund) buy a fixed income security after its issue date, or sell before the maturity date, you may get more or less than the issue price because the price of a fixed income security has an inverse relationship to that security’s yield.
As illustrated in figure five, when the yield decreases, the value of a fixed interest security increases. Likewise, an increase in the yield results in a decrease in the security’s price. Changes in the price of fixed income securities have the equivalent impact on the security’s yield.
For illustrative purposes, assume a $100 par value with an interest rate of 5% pa with a duration of 4 years.
Fixed income has a natural buyer in the issuer, who is required to pay back the loan at par value when it matures. This, along with its regular coupon payments, gives fixed income a greater predictability of returns and, in turn, makes this asset class an important part of a diversified portfolio.
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