What is Fixed Income?
Fixed Income describes securities where investors provide capital to corporations or a government for a set duration in return for regular interest payments and the original principal at maturity.
Fixed Income Securities: Investment Product Characteristics
Fixed income securities pay fixed interest expenses throughout the lending term until the date of maturity, which is when the full principal amount comes due.
As part of the financing transaction, the investor is compensated by:
- Periodic Interest Payments
- Original Principal Amount
Unique to the fixed income asset class, the focus is on capital preservation and a steady source of income – with the typical issuer comprised of governments and corporates.
Fixed Income Market Overview
Of the fixed income products issued, the top issuers are:
- Governments (Local, State, Federal)
- Corporate Issuers
Companies raise capital via fixed income issuances – i.e. corporate bonds – to fund their operations and to finance their growth plans. The type of companies that issue fixed income securities are typically mature, established companies, as opposed to early-stage high-growth companies.
Companies with low default risk are unlikely to miss interest payments or repay the principal (i.e. contractual breach), so risk-averse investors lend specifically to these types of companies.
Given the risk profile of most start-ups, finding adequate interest in the market (and at borrower-friendly lending terms) is improbable.
The purpose of government-issued securities is typically related to funding public projects (e.g. infrastructure, schools, roads, hospitals). For instance, a municipal bond is backed by a state or municipality, as opposed to the federal government – and is often exempt from taxes.
Fixed Income Securities Examples
The most common examples of fixed income products consist of the following:
- Treasury Bills (T-Bills)
- Treasury Notes (T-Notes)
- Treasury Bonds (T-Bonds)
- Corporate Bonds
- Municipal Bonds
- Certificates of Deposit (CDs)
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Capital Preservation
- Reduced Downside Risk (Capital Loss Potential): For investors, the notable advantage of fixed income is the reduced risk and potential for loss of capital. As a more conservative investment strategy, fixed income is more predictable in terms of returns (i.e. a steady source of income). Hence, investors that prioritize capital preservation and risk minimization tend to invest in fixed income (e.g. retirement funds).
- Less Sensitive to Macroeconomic Conditions: Compared to equities, fixed income is much more stable and carries fewer risks due to having less sensitivity to macroeconomic risks (e.g. recessions, geopolitical risk).
- Portfolio Diversification: In fact, even larger institutional funds often allocate a certain percentage of their portfolio into fixed income securities to diversify their portfolio.
Higher Claim in Capital Structure
- Priority Claim: Another benefit to fixed income is that the majority are debt instruments, so their claims on the underlying borrower (i.e. corporate bonds) are higher relative to equity in the capital structure.
- High Recovery Rate (%): If the corporate borrower were to default and become distressed, fixed income debt holders are better positioned to receive a recovery rate of 100% or most of their original lending amount back, i.e. “paid in full”.
Risk/Return Trade-Off
- Lower Yield: Since increased risk means that investors should be compensated more for taking on the incremental risk, the lower risk of fixed income results in lower returns. However, lower returns in exchange for capital preservation are a fair trade-off for many participants in the fixed income market.
- No Default Risk: In particular, government-backed securities come with the lowest degree of risk – hence, the risk-free rate as used in corporate finance is most often the yield on the 10-year Treasury. The safety of government bonds is due to the fact that the government could hypothetically print more money if it needed to, so the default risk is practically zero in theory.
Risks of Fixed Income Securities
There are four common risks associated with the fixed income market:
- Interest Rate Risk: If interest rates increase, bond prices fall (and vice versa).
- Inflation Risk: If the rate of inflation outpaces the income from the bond, the actual returns are lower.
- Credit Risk (or Default Risk): If the issuer defaults on its debt obligations, the investors might not receive the original principal back (or only a portion of the full value).
- Liquidity Risk: If an investor attempts to exit their fixed income security but is unable to find an interested buyer in the market, a lower offer might have to be accepted to sell the investment.
