Fixed Income Investment

Fixed income, or bonds, constitute a class of assets that offer consistent cash flows via dividends or fixed interest. Typical examples are government and corporate bonds with interest payments often referred to as coupons.

Fixed income investments are initially sold to investors on the ‘primary market’. After their initial issue, they may be traded on the ‘secondary market’ or directly between institutional holders.

It’s worth understanding the following terminology:

• Par value: the face value of the investment and the amount repaid on maturity (often priced in increments of £100 or £1,000)
• Coupon: the rate of interest paid per year based on a percentage of the par value of the bond. The coupon, also known as the ‘nominal’ yield, is typically a fixed amount paid once or twice a year
• Market value: the current trading price of the investment
• Maturity: the redemption date on which the original investment is repaid
• Risk: the likelihood of the issuer defaulting on their repayment. The riskier bonds tend to have higher coupons. Agencies such as Standard & Poor’s (S&P), Moody’s and Fitch provide risk ratings for fixed income investments with the highest rating (lowest risk) being AAA, followed by AA, A, BBB and so on.

What are the types of fixed income investments?

The two main types of fixed income investments are:

• Government bonds: issued by governments, known as ‘gilts’ in the UK and ‘treasuries’ in the US. Most gilts have a fixed coupon but some are index-linked to measures of inflation such as the UK Retail Prices Index and may therefore help to hedge against inflation
• Corporate bonds: or ‘non-gilts’: issued by companies and banks, mostly with fixed coupon rates. These are split into investment grade (S&P AAA-BBB) and speculative grade or high yield (BB or lower). Speculative grade or ‘junk’ investments pay a higher coupon rate to compensate investors for the higher risk of default.

How do Fixed Income Investment works?

Fixed income investments focus on providing a reliable stream of income. The most common fixed income investments are usually bonds, which are fixed term loans issued by companies and governments looking to raise money. UK government bonds are called Gilts, whilst in the US government bonds are known as Treasury Bills, or T-Bills, and German federal bonds are referred to as Bunds.

A bond issuer will pay investors a fixed rate of interest for a set period, at the end of which the loan is repaid. Investing in individual bonds can be particularly risky, as their fortunes rely on the specific issuer, whether a corporation or government, and therefore in case of insolvency (or political events) they may fail to repay your investment and you could lose money.

As a result, many investors opt to put their money into funds that invest in bonds. This helps reduce the risk because rather than just buying bonds from a single issuer, your money is spread between range of different fixed income holdings. Some bond funds will invest solely in a basket of bonds issued by companies, while others will focus purely on government bonds, and some will invest in a combination of these. As with all investments the rule of thumb is that the higher the potential return on offer, the riskier the investment. Bonds which are rated from AAA down to BBB by credit ratings agencies such as Standard & Poor’s or Moody’s are classified as ‘investment grade’ and are deemed to be lower risk.

Generally, fixed-income investments are considered less risky than shares, with income from bonds being paid out before any dividends on shares, and bond payouts taking priority over shareholders in the case of insolvency.

Bonds can usually be sold before their maturity date but their market value will change over time and may be affected by any fear of a government failing to repay or a particular issuer facing financial difficulties. The perception of the issuer’s ability to pay will reduce the value of the bond, which is also affected by credit agency assessments and ratings. This means that when you sell your investment in the market you may get back less than you originally put in. The value of a bond will also be affected by changes in general interest rates.