What is Fixed Income?
Fixed income is a financial instrument that pays investor interest payments and ends by paying the principal on maturity.
Fixed income usually covers preferred stock, structured products (Mortgages and assets), multiple bond classes. Bonds form the basis for understanding the fixed income terms and concepts.
Think of it as another name for fixed income. In the wall street, their usages pretty much mean the same thing.
Let’s define a bond. What is a bond?
Bond is a loan. You buy a bond, you are lending your money to someone who asked for money or raising money for a project(corporation).
The borrower is legally obligated to pay you (the bondholder) with periodic interest payments (also called as coupons). The final payment with principal occurs in a future date, called a bond’s maturity date.
Fixed Income Markets
Two different market system is available based on investor needs and requirements.
All the new bonds are issued and distributed in the primary market. Investment banks play a major role in the distribution process.
Investment bank buys the bonds and is responsible for bringing the bond to the market. They are also given an obligation to conform to the regulations set by the Securities and Exchange Commission (SEC).
Let’s look at it with a real-world example. New York City wants to build a bridge connecting New Jersey and it needs to raise $200 million to finance the project.
NYC lets everyone (investment banks etc.,) involved know that they are looking for raising money and asks for a bid.
Now everyone competes for the bid or they join together and offer a bid. Let’s say in this case, Goldman Sachs makes a successful bid and gets the contract.
Next, Goldman Sachs is fully responsible for selling the bonds to the investor. Major banks, hedge funds, insurance companies are the major investors.
Now, how Goldman Sachs make money from it? Goldman Sachs buys all the bond from NYC and sells it at a higher rate.
All the existing bonds trade among different investors. Dealers involved in the secondary market usually purchase bonds and sell them at a higher rate for profits.
Bonds in the secondary market are not usually active and wall street term is ‘gone away’. The prices of these bonds fluctuate from high to low but don’t trade at the par or initial value.
Commonly used fixed income terms
From our example in the sale of NYC bonds to investors, there are underlying obligations for NYC to pay the investor. This legal document is known as indenture.
Think of prospectus as a summary of indenture. It contains information about maturity date, collateral, etc.,
After the sale of the bonds, this is usually called Official Statement.
Bid, Ask and Spread
Bid and Ask are the price quoted in the market to represent the buy/sell price of the bond. For example, a bond may be said to have 94 bid/ 98 ask. If you buy you are paying 98 and 94 if you are selling.
The difference between Bid and Ask is known as the spread.
The spread is usually a good indicator of the bond’s liquidity. A narrow spread means the bond has high demand and low risk.
Type Of Issuer
If someone is raising money, then someone is termed as the ‘issuer’. These are usually Federal government and its agencies, corporation (domestic, international), municipal governments.
The U.S. Treasury has a wider market share and is the dominant player in the fixed income market.
Maturity also called term-to-maturity is the number of years in which the borrower will pay the debt.
Principal and Coupon
A principal is the original amount of the debt (the value of the loan). Its also called par value or face value.
The coupon is the interest payments received by the investor through to the maturity. In the US, the coupon payment is made every 6 months.
Types of Fixed Income Products
Bonds types in the US
Bonds issued directly by the US Treasury which are backed in full faith by the US government is called as Treasury bonds. The amount issued is usually in billions.
Bonds issued by the Corporations are known as corporate bonds and they are around $500 million.
Bonds issued by the local municipalities are known as munis. They are within the range of $100 to $500 million.
While it is actually part of stocks, it is viewed as a fixed income instrument because of its payments made to the investor based on the face value.
The distinguishing factor of structured products with fixed income is that the return of the structured products is tied to the underlying group of products.
The following products are generally known for their complexity and 2008 financial crisis.
Mortgage Backed Security (MBS)
What are mortgages?
A mortgage is usually a loan issued over the purchase of the real estate.
MBS instrument is made by grouping a pool of mortgage loans. For example, an Investment Bank can buy 1,000 mortgage loan and resell it as a single MBS security (also known as securitization).
Commercial Mortgage Backed Security (CMBS)
As the name indicates, its the MBS but the underlying loans are given for apartments, hotels, industrial properties, etc.,
Asset-Backed Securities (ABS)
Any securities which aren’t backed by anything other than mortgages are called asset-backed securities.
Student loans, vehicle loans, boat loans, etc., are examples of ABS.
Fixed Income Investment
As with stocks, fixed income investment can also return greater return based on the risk.
Commonly investment products in portfolios include Certificates of Deposit(CD) and bond mutual funds. There are also bond ETFs which operate similar to Equity ETFs.
For riskier investment (known as Junk Bonds), the reward is high yield.
Risks involved in Fixed Income Investment
The return of investment is impacted by many market factors. The different types of risk that an investor should expect is:
- Interest rate risk
- Credit risk
- Maturity risk
- Inflation risk
Interest Rate Risk
Price always moves in the opposite direction of the interest rates. If you plan to hold the security to maturity then interest rate risk is not of concern.
A bond’s credit risk include default risk (bond issuer defaults on their payment), downgrade risk (when similar bonds lose value), and credit rating (third party companies rate the bonds based on its characteristics).
To compensate for losses one may incur in a bond, another bond is bought with different maturity.
The interest rate difference which may occur between them both constitutes yield curve risk or maturity risk.
Inflation risk rises when the cash flow value loses its power. For example, if you buy a bond which has a coupon rate of 3% and the inflation is 3.5% then the purchasing power of the cash flow is down (-0.5%).
A fixed rate bond is exposed to the inflation risk and the opposite is true for the floating rate bonds.