Fixed Income: The Perfect Guide

Asset classes

Fixed Income
  • Fixed income is a class of assets and securities which pay predefined fixed cashflow.
  • It often pays interests or dividends.
  • When the asset arrives at maturity, investors are paid back for their original investment.

When you ask the average person about fixed income trading, you might get confused. They’ll probably point you to a pension statement or social security checks due to the phrase “fixed income”.

Bankers consider it as everything that isn’t equities. This is a more apt description at a bank. Fixed income includes a wide range of various desks and is more difficult to generalize than equity trading.

Fixed income currencies, and commodities (FICC) groups at banks employ more people and create more revenue than Equities groups. Also, they may offer advantages in terms of the work and exit opportunities.

What does Fixed Income mean?

Fixed income is broadly known as those types of investment security that pay investors fixed interest or dividend payments until they mature. When they mature, investors are repaid the principal amount they had invested. Corporate and government bonds are the most common types of products.

Unlike equities fixed income may pay no cash flows to investors. Payments can change based on some underlying reasons. The reasons may be short-term interest rates, payments of a fixed income security, and investors know them before they occur.

Fixed income trading has to do with the buying and selling of securities, including government and corporate bonds. Organizations and governments agencies issue debt securities to raise funds for daily operations and finance big projects.

Investors see these products as instruments to pay a set interest rate return in exchange for investors lending their money. When the mature, investors get repaid the original amount they had invested, known as the principal.

Fixed income securities are ideal for conservative investors looking for a diversified portfolio. The percentage of the portfolio depends on the investment style of the investor. There’s also an opportunity to diversify the portfolio with some FI products and stocks.

Special considerations

Fixed income investing is a conservative strategy that generates returns from low-risk securities. Those securities pay predictable interest. Because the risk is lower, the interest coupon payments are also lower.

Building a fixed income portfolio may include investing in bonds, mutual funds, and certificates of deposit (CDs). One strategy that uses FI products is the laddering strategy.

A laddering strategy provides steady interest income through the investment in various short-term bonds. As the bonds mature, the portfolio manager reinvests the returned principal in new short-term bonds to extend the ladder.

This method makes it possible for investors to have access to ready capital and avoid losing out on rising market interest rates.

For instance, you can divide a $45,000 investment into one-year, two-year, or three-year bonds. The investor shares the $45,000 principle into three equal portions, investing $15,000 into each of the three bonds.

After the one-year bond matures, the $15,000 principal will roll into a bond maturing one year after the original three-year holding. When the second bond matures they roll into a bond that extends the ladder for another year. By doing this, the investor has a steady return of interest income and can take advantage of any higher interest rates.

Types of Fixed Income products

The most common example of a fixed-income security is a government or corporate bond. The most common government securities are those provided by the U.S. government and is mostly known as Treasury securities.

But a lot of fixed income securities are also given from non U.S. corporations and governments. Below are the most common types of products:

Treasury bills (T-bills)

These are short-term fixed-income securities that mature within one year that do not pay coupon returns. Investors buy the bill at a price less than its face value and investors earn that difference at the maturity.

Treasury notes (T-notes)

They come in maturities between 2 and 10 years. They pay a fixed interest rate and sell in multiples of $100. After they mature, investors are repaid the principal. However, they earn semiannual interest payments until maturity.

The Treasury bond (T-bonds)

T-bonds are similar to the T-note, except that it matures in 20 or 30 years. You can buy these bonds in multiples of $100.

Treasury Inflation-Protected Securities (TIPS)

It protects investors from inflation. The principal price of a TIPS bond changes with inflation and deflation.

Municipal bond

A municipal bond is similar to a treasury because it a government issues it. It backed by a state, municipality, or county, rather than the federal government. Also, it applied in raising capital to finance local expenditures. These bonds also have tax-free benefits to investors.

Corporate bonds

They come in various kinds. The price and interest rate provided greatly depends on the financial stability and creditworthiness of the company. Bonds having higher credit ratings typically pay lower coupon rates.

Junk bonds

Also referred to as high-yield bonds, are corporate issues that pay a higher coupon because of the higher risk of default. Default occurs when an organization fails to pay back the principal and interest on a bond or debt security.

Certificate of deposit

A certificate of deposit (CD) is a vehicle provided by financial institutions with maturities of less than five years. The rate is greater than a typical saving account. CDs carry FDIC or National Credit Union Administration (NCUA) protection.

Fixed income mutual funds

These funds allow investors to have an income stream with the professional management of the portfolio. But they will pay a fee for the convenience.

Asset-allocation

Also called fixed income ETFs, it works much like a mutual fund. The funds target particular credit durations, ratings, or other factors. It also carries a professional management expense.

Benefits of Fixed Income

Fixed income investments provide a steady stream of income for investors. This income lasts throughout the life of the bond or debt instrument. It simultaneously offer the issuer much-needed access to capital or money. Steady income allows investors plan for spending, this is why these are popular products in retirement portfolios.

Also, the interest payments from FI products can help investors stabilize the risk-return in their investment portfolio. This is the market risk. For investors that have stocks, prices can change and lead to either large gains or losses.

The steady and stable interest payments from fixed income products can offset losses from the decline in stock prices. Due to this, the safe investments help to diversify the risk of an investment portfolio.

Who should consider it Fixed Income assets?

The investor who wants to make maximum capital gains should invest in low-rated securities. If interest rates are probably going to fall in the future, investing fixed income securities leads to high capital gains.

Less risky-taking investors should invest in securities with short maturity periods to reduce interest rate risk. They can also invest in high credit rating securities to avoid default risk.

Conclusion

There are various fixed income investments and investment strategies available for people to use. An investor should ensure he or she carries out adequate research on any opportunity before investing.

Most bonds have long maturity dates such as ten years or higher. When you invest in a bond, you will tie up most of your investment capital for a long time. You have to make sure to the best use of money with your investment choice.

Although there are many benefits to fixed income products, as with all investments, there are several risks investors should be aware of before buying them.

Fixed income products are part of a balanced portfolio and behave differently in the different market cycles.

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