Guide to fixed income
Fixed income, as the name suggests, is a type of investment where the borrowing entity agrees in advance to pay the holder, or the investor, a set amount of interest for a given period of time, otherwise known as a bond. Although there are many different types, there are two key issuers of bonds – Governments, i.e. bonds which are issued by governments (known as Gilts in the UK) and Corporates.
Although bonds are often perceived as complex and confusing the fundamentals of bond investments are surprisingly straightforward.
What is a bond?
A bond is an agreement between whoever is issuing the bond and the buyer. The bond owner is agreeing to lend the issuer the face value of the bond, with the issuer agreeing to repay the initial sum on a fixed date, while in the meantime paying the owner a regular income (usually once or twice a year) in the form of a coupon payment.
The most fundamental differentiating aspects between different bonds are the characteristics and the security of the entity issuing them. Why? Because this determines the return an investor can expect, the associated risks and the types of factor likely to determine its performance. Bonds issued by institutions such as the UK or US governments are considered to be very safe, with a negligible chance of the issuer defaulting on either the regular coupons or the repayment of the face value.
The characteristics of corporate bonds, however, vary considerably with the nature of the company issuing them. If a bond is issued by a large, financially stable firm, there is little chance of it failing to pay its coupons or face value on maturity. This is commonly called an investment grade bond. Those issued by a company with less secure characteristics meanwhile, are known as high yield bonds because the issuing company has to compensate investors for the additional risks to which they are exposing themselves by paying a higher regular income to its bond holders.
In much the same way as a bank does when you apply for a mortgage, ratings agencies like Moody’s and Standard & Poor’s assess the credit worthiness of the issuer before allocating its bonds a rating based on its financial (and non-financial) health.
What makes bonds attractive?
Although bonds can increase in value over time, their biggest attraction is the regular income stream they may provide. Historically, they have also been less volatile than shares, meaning that they are normally preferred by more cautious investors, and can play an important part in a balancing a broader investment portfolio.
What are the key risks associated with bonds?
Bonds are traditionally known as relatively low risk, especially when compared to equities. However, there are some key risks which should be considered;
Credit Risk: The risk that the company or government issuing the bond fails to make payments.
Liquidity risk: The ease with which a bond can be bought or sold (this comes into play with bond funds, which we’ll look at in more detail below).
Interest Rate Risk: If interest rates rise, the attractiveness of bonds begins to decline as the opportunity to make money in cash becomes greater (this is only an issue when selling a bond before maturity, which bond fund managers do most of the time. This is explained below).
Currency Risk: If international bonds are bought, there is a risk that exchange rate fluctuations may cause the value of the bond to change.
How does a bond fund work?
As with all collective investment schemes, fund managers (or investment experts) will pool investors’ money together and buy a number of bonds. The fund manager will normally sell a bond before maturity, i.e. before the issuer repays the bond face value – to meet withdrawals from the fund and regular payments to investors.
The Net Asset Value (NAV) of the a bond fund will vary through time depending on the underlying level of interest rates and the credit worthiness of the issuers of the bonds held by the fund. The fund manager may choose to buy or sell bonds held within the fund before they reach maturity but this will depend on whether the price of the bond has risen or fallen or changed relative to other similar bonds available in the market. Over time new bonds will be issued by the borrowers and they may offer the fund managers better or alternative investment opportunities.