Fixed Income (Bonds and more)

Asset Classes within the Financial Markets

Fixed Income (Bonds & more) Defined

Fixed Income is a category of investment security that pays investors fixed interest or dividend payments until its maturity date. At maturity, investors are repaid the original or principal amount they had invested. Government, Sovereign and corporate bonds are the most common types of fixed-income products alongside pensions and loans. Unlike equities that may pay no cash flows to investors, or variable-income securities, where payments can change based on some underlying measure—such as short-term interest rates—the payments of a fixed-income security are known in advance.

Types of Fixed Income

There are four broad categories of fixed income investments. Short-term products return a low rate, but you only tie up your money for a few months at most. Long-term products pay a higher rate, but you must leave your money invested for years.

Short-Term

The interest rates on short-term fixed-income accounts are based on the Bank Rate (Base Rate) or T-Bill rates of four years or less.  Businesses use short-term loans to cover the cash flow needed to pay for day-to-day operations.

  • Savings Accounts: The bank pays you a fixed rate of interest, based on the bank rate. You can add or withdraw whenever you like.
  • Money Market Accounts: The bank pays you a slightly higher fixed rate of interest. In return, you must keep a minimum amount deposited. You are limited in the number of transactions you can make in a year.
  • Certificates of Deposit: You must keep your money invested for an agreed-upon period to get the promised rate of return. 
  • Money Market Funds: These are mutual funds that invest in a variety of short-term investments. You get paid a fixed rate based on short-term securities. These included Govt. bills, notes, and Currency deposits. They also included repurchase agreements, certificates of deposit, and corporate commercial paper. They are also based on obligations of  other types of government agencies. 
  • Short-term Bond Funds: These mutual funds invest in one-year to four-year low-risk bonds. Most of their holdings are corporate bonds.
Long-Term

Long-term fixed-income investments are called bonds. They are how organizations get substantial loans. Unlike loans, bonds can be bought or sold like any security. The interest rates on these accounts follow Govt. notes and bonds. The rate depends on the duration of the bond. 

Bond prices go down when stock prices go up. Bonds are lower return and lower risk than stocks. Investors buy them when they want to avoid risk.

Here are the different types of bonds.

  • Government bonds are the safest because they are guaranteed. Since they’re the safest, they offer the lowest return. U.S. Treasury notes and bonds are the most popular, with $16.6 trillion outstanding in 2019.1 Savings bonds are also guaranteed by the U.S. Treasury. They are designed for smaller investors.
  • Corporate bonds offer a higher rate. Companies sell them when they need cash but don’t want to issue stocks. There are currently $8.1 trillion in these bonds outstanding.
  • There are two hybrids of corporate bonds and stocks. Preferred stocks pay a regular dividend, even though they are a type of stock. Convertible bonds are bonds that can be converted to stocks. Stocks that pay regular dividends are often substituted for fixed-income bonds. Although they are not technically fixed income, portfolio managers often treat them as such.
  • Eurobonds is the common name for Eurodollar bonds. They are corporate bonds issued in euros instead of their own country’s currency or U.S. dollars. 
  • Bond mutual funds are mutual funds that own a large number of bonds. That allows the individual investor to gain the benefits of owning bonds without the hassle of buying and selling them. Mutual funds grant greater diversification than most investors could obtain on their own. 
  • Exchange-traded funds (ETFs) track the performance of a bond index. They aren’t actively managed like a mutual fund. Bond ETFs are popular because they have low costs.

Fixed Income Derivatives

There are many financial derivatives that base their value on fixed income products. They have the most potential return because you invest less of your money. But if they lose money, you could lose much more than your initial investment. Sophisticated investors, companies, and financial firms use them to hedge against losses.

  • Options give a buyer the right, but not the obligation, to trade a bond at a certain price on an agreed-upon future date. The right to buy a bond is called a call option. The right to sell a bond is the put option. They are traded on a regulated exchange. 
  • Futures contracts are like options, except they bind participants to execute the trade. They are traded on an exchange.
  • Forward contracts are like futures contracts, except they are not traded on an exchange. Instead, they are traded Over the Counter (OTC), either between the two parties directly or through a bank. They are often very customized to the particular needs of the two parties.
  • Mortgage-backed securities derive their value from bundles of home loans. Like a bond, they offer a rate of return based on the value of the underlying assets.
  • Collateralized debt obligations base their value on auto loans and credit card debt. Sometimes they use bundles of corporate bonds for their value.
  • Asset-backed commercial paper are one-year corporate bond packages. They are based on underlying commercial assets. These include real estate, corporate auto fleets, or other business property.
  • Interest rate swaps are contracts that allow bondholders to swap their future interest rate payments. These are between a holder of a fixed-interest bond and one holding a flexible-interest bond. They trade Over The Counter. Swaptions are options on an underlying interest rate swap. They are a derivative based on a derivative. They should only be used to speculate about interest rate movements.
  • Total return swaps are like interest rate swaps, except the payments are based on bonds. They can also derive their value from a bond index, an equity index, or a bundle of loans. 

Third-Party Fixed Income Payment Streams

Some fixed income streams don’t depend on the value of an investment. Instead, the payment is guaranteed by a third party.

State Pension

Fixed payments available after a certain age. It’s guaranteed by the government and is calculated based on payroll taxes you’ve paid. It’s managed by the State Pension Fund.

Private Pensions

Fixed payments guaranteed by your employer, based on the number of years you worked and your salary. Companies, unions, and governments use pension funds to make sure there’s enough to make the payments. As more workers retire, fewer companies are offering this benefit. 

Fixed-Rate Annuities

Fixed-rate annuities are an insurance product that guarantees you a fixed payment over an agreed-upon period. These are increasing since fewer workers receive pensions. One variation of this product that can provide some long-term upside is a variable annuity. In certain cases, it can offer an agreed-upon fixed payout stream, which is underwritten based on a basket of equities funded with your initial contribution. The basket of equities can increase the value of the annuity in the event of a major increase in the equity market, but still provide a base level fixed income.

How Fixed Income Affects the Economy

Fixed income provides most of the liquidity that keeps the economy ticking over. Businesses go to the bond market to raise funds to grow. They use money market instruments to get the cash needed for day-to-day operations.

Treasury bills, notes, and bonds help set interest rates. How? When demand for Treasury bonds falls, yields rise. Investors then demand higher interest rates on similar fixed-income investments. That send rates higher on car finance, credit cards and home loan mortgages.

Inflation

Low-interest rates might trigger inflation. That’s because there’s too much liquidity chasing too few goods. If inflation doesn’t show up in consumer spending, it might create asset bubbles in investments.

You can also use Treasury yields to predict the future. For example, an inverted yield curve usually heralds a recession. When that happens, it has the same effect on mortgage interest rates. It affects the demand for real estate, which supports a large percentage of the economy. Bonds affect mortgage interest rates because they are competing with the same investors. When bond rates fall, then mortgage rates must too.

The Value of Currency

The demand for Treasury notes is one also of the three factors that affect the value of the country’s currency. That’s because both are seen as safe-haven investments, and tend to rise and fall together. But sometimes the expectation of high-interest rates will drive up demand for the currency. 

Demand for fixed income investments skyrocketed after the 2008 recession and in 2019 as a result of the worldwide Covid-19 pandemic. That’s because the monetary policy of several countries has kept interest rates at a record low for an ongoing long period of time. Risk-averse investors shifted more of their portfolios to fixed income products.  

 

Fixed Income Markets (BONDS)

Typical investments: Bonds, debentures, gilt-edge bonds

Risk profile: Low

Fixed-interest investments — sometimes known as fixed-rate securities — are an asset class that sees investors loan their money to a company or government in exchange for a security, in the form of a bond or similar product, that pays an agreed rate of interest. This rate remains the same throughout the duration of the investment. When the investment matures, you’ll also be paid back the original amount you put in.

Read more about Fixed Income here

Typical investments: Purchase of equity in a company listed on the stock exchange

Risk profile: Medium to high

When you buy shares — also known as equities — you are buying a small portion of ownership in a company. Each share represents a unit of ownership, so the company value is divided by the number of shares to give the share price. Shares are traded on the stock market, where the daily value of each company’s shares are listed.

There are a number of factors, such as if the company does well or undergoes a merger, that can cause the value of a business to increase and boost the worth of each share. On the other hand, if the company does badly, the shareholders can face a drop in the worth of their shares. 

Find out more about Equities here

Typical investments: Physical currency, bank accounts, savings accounts, cash ISAs

Risk profile: Low

Cash is the asset class that you’re probably most familiar with, as we use it on a daily basis to pay for goods and services. The asset class for cash includes physical currency, the balances of savings and current accounts, cash ISAs, premium bonds, and money market funds.

Read more about Cash Equivalents here.

Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. Here, the buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.

Underlying assets include physical commodities or other financial instruments. Futures contracts detail the quantity of the underlying asset and are standardised to facilitate trading on a futures exchange. Futures can be used for hedging or trade speculation.

Accordion Content

Typical investments: Oil, coffee, gold

Risk profile: High

Commodities are raw materials that are bought and sold on global markets where supply and demand, as well as other global issues, dictates the price. They can include fuels like oil and gas; precious metals like platinum, gold and silver; agricultural products like wheat, coffee, and dairy products; industrial metals like copper, iron, and steel; as well as many other things. A lot like shares, commodity markets regularly rise and fall, but they tend to be much more volatile.

Find out more about Commodities here

Typical investments: Buying your own home or a holiday home, investing in buy-to-let and commercial projects.

Risk profile: Medium

Investing in property can take many forms, such as buying your own home or getting involved in commercial property, like offices, warehouses, and retail space. There are opportunities to invest in both small and large-scale projects, ranging from a single buy-to-let to joining an investment fund that owns large-scale commercial sites. 

Find out more about Real Estate here

Typical investments: Cryptocurrency, Art and antiques, wine, watches, peer-to-peer lending

Risk profile: Low to high depending on investment

Aside from the main five asset classes, there are other areas that you can invest in to really add diversity to your portfolio, though it’s worth remembering that each will have its own levels of risk and reward that you should research. 

Although these fall outside of the traditional asset classes, many alternative types have been traded in for a very long time. Art, antiques, stamps, watches, wine, and jewellery are all examples of valuables that have been traded for centuries. On the other hand, there are many new asset classes that have only emerged in the last few years, such as cryptocurrencies and peer-to-peer lending, demonstrating just how diverse the investments marketplace can be. 

To find out more about alternative investments here

Contact Us

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