Fixed income is a defensive asset class that plays an important role of generating income and reducing volatility in a well-diversified investment portfolio. The global fixed income market is much larger than the stock market and nearly every economy around the world has its own market, each with its own set of issuers, intermediaries and securities.
The seven modules below review the fundamentals of this asset class.
The most common fixed income investment is referred to as a bond.
A bond sits within a portfolio’s fixed income allocation alongside products such as cash and term deposits. These assets are classified as income assets as they provide a steady and reliable stream of income.
A bond is often referred to as a type of debt security and operates like a loan. You lend your money to an issuer—usually a government or a company—for a set period of time. The issuer agrees to make regular payments at a set rate of interest and then pay you back in full when the bond matures at the end of the term.
The bond market is extremely diverse, ranging from relatively safe government bonds to corporate bonds that can come with more risk. Bonds are classified as defensive assets because they are generally less risky than growth assets like shares, however, companies and even governments can default on their bond obligations.
You can hold a bond until maturity or trade it on the bond market. Bonds are continually traded and their capital value changes in line with interest rates and other factors. Most traders are large banks, brokers and fund managers, which buy and sell bonds to profit from price fluctuations or generate coupon income.
It’s important to know that bonds have both a face value and a capital value.Most bonds make regular coupon (or interest) payments over the term of the bond.
The capital value is what the bond is worth when it’s bought and sold on the market. While the face value is fixed, the capital value can vary during the term, depending on factors such as interest rates, economic conditions and the time since the last coupon payment.
When interest rates rise, bond prices fall. And when interest rates fall, bond prices rise.
Let’s say you bought a 10-year bond that pays 4% interest a year. If market interest rates fell, the income you receive from your bond would be more valuable to potential buyers and the capital value of your bond would increase. But if interest rates rose, the income from your bond would be less valuable and the capital value of your bond would fall.
The table below shows the relationship between interest rates, bond prices and the yield, which represents the expected return for new buyers if the bond is traded on the market.
If you’ve invested in an individual bond, you only need to worry about changes in the capital value of your bond if you sell it before maturity.
If you hold a bond until the end of its term, you’ll receive back the face value of the bond.
If you’re invested in a bond fund, you could actually benefit from falling bond prices because the fund will be able to invest in new bonds at a lower market price.
The bond market tends to benefit from increased investment in volatile markets as investors look to reduce their exposure to shares.
Bonds with longer to maturity are more sensitive to changes in interest rates.
Bond prices can be affected by changes in the issuer’s credit risk.
One of the primary advantages of investing in individual bonds is the ability to control cash flow by matching a bond’s maturity date with specific income needs.
It can, however, be quite costly to go out and buy a portfolio of bonds with an adequate level of diversification. There are typically large transaction costs involved and there is only a relatively small selection of bonds available to trade in small parcels. This is why most participants trading in these markets are major financial institutions or large investors.
It can be much more convenient, and cost effective, to capture bond market returns by investing in a bond fund rather than individual bonds.
Bond funds come in a variety of bond investment strategies, across government and corporate issuers, and are a much cheaper means of acquiring an exposure to a broad set of bonds. Investing this way costs less because managed funds have access to institutional pricing (that is on far more favourable terms than retail pricing) by transacting in much larger market parcels.
These funds are collections of bonds that are intended to mirror the performance of a particular market benchmark or index. The primary advantage of bond index funds is their low costs and diversified holdings.
Bond ETFs are similar to conventional bond index funds. However, as ETFs are traded throughout the day like individual securities, bond ETFs offer additional trading flexibility not available from conventional bond index funds.
These funds are managed by individual investment managers that pick bonds with the intention of outperforming a fund’s benchmark. Actively managed bond funds offer investors the opportunity for higher returns than bond index funds, though usually at relatively higher costs.
Bond credit ratings are important because they indicate how much an issuer must pay to borrow money and compensate investors for assuming credit risk (the chance that a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of a bond to decline).
The lower a bond’s credit rating, the higher the interest rate the borrower must pay to entice investors to purchase the bond. Moody’s and Standard & Poor’s are the major bond credit-rating agencies, and though their rating systems are similar, they are not identical.