What is fixed income?

Fixed income is a defensive asset class that can play an important role in a well diversified investment portfolio.  It is generally considered lower risk than shares, and provides regular interest payments that can be an ideal way to produce a steady source of income.

The most common fixed income investment is referred to as a bond. 

  1. What is a bond?
  2. Types of bonds
  3. How do bonds work?
  4. How interest rates affect bond prices
  5. Investing in bonds
  6. Bond credit ratings

What is 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. They are also known for their lower risk profile which is why they don’t offer the same capital growth potential that riskier growth assets such as shares offer.

A bond operates like an IOU, whereby you lend your money to an issuer for a set period of time in return for interest payments over the term of your investment. Your investment, or capital, is then paid back to you in full at the end of the term known as ‘maturity’.

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Types of bonds

As an investor you can choose from a wide array of investment options as bonds come in a range of credit qualities and maturities and from a variety of issuers.

The main types are:

Government bonds

Issued directly by a government and are explicitly guaranteed. For instance, in Australia the Federal Government issues Commonwealth securities to help pay for major government projects.

Semi-government bonds
Not issued directly by a government but might have a direct or implied guarantee. For instance, state governments and other entities that have a government guarantee (like the World Bank), issue bonds to support their financial needs or to finance public projects.

Corporate bonds
Issued by large public companies to fund expansion and other major projects, corporate bonds differ in two important ways to government bonds; in yield and credit quality. Generally, corporate bonds are thought to have a higher level of risk than government or state government bonds, so they typically offer higher interest rates.

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How do bonds work?

Bonds

As Figure 1 above shows, all bonds have the same basic structure: a schedule of coupon (or interest) payments and the return of the capital amount upon maturity. Incidentally, the interest you receive on a bond is called a coupon because back in the day, investors actually clipped coupons from paper bonds and presented them to get their interest. The coupon reflects the term of the loan, the prevailing level of interest rates, and the borrower’s creditworthiness at the time of the loan.

In addition to holding bonds to maturity, you can also trade them in the secondary market before maturity. Existing bonds are constantly being traded around the world, and their value changes along with market interest rates. These secondary markets are usually the domain of professional investors such as large banks, brokers and fund managers who trade bonds with the aim of profiting from price fluctuations or generating coupon income among other objectives.

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How interest rates affect bond prices

The inverse relationship between bond prices and interest rates can be confusing, but we can think of it as a kind of seesaw. Suppose you are invested in a 10-year bond that pays 4.5% in interest. If interest rates rise to 5.5%, other investors will be able to buy new bonds that pay better. So if no-one is willing to pay full price for a 4.5% bond, and you want to sell your bond you would have to take less than its face value. But if interest rates fall instead, and new bonds are offered with a 3.5% rate, you’ll probably be able to sell your bond for more than you paid.

Investors who hold bonds as part of a long-term strategy shouldn’t worry too much about these price declines. In fact, for a long-term investor, news that bond prices are falling is a real positive. Why? Because the fund will be able to invest in new bonds that pay higher interest rates. Over the long term, reinvested interest payments will be the source of most of the wealth accumulated in an investment in bonds.

Bonds

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Investing in bonds

Individual bonds
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 your 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.

Bond funds
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.

Types of bond funds

Bond index funds
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.

Bond exchange traded funds (ETFs)
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.

Actively managed bond 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.

Factors to consider when investing in bond funds

Credit quality
Independent bond-rating agencies, such as Standard & Poor’s and Moody’s Investors Service, evaluate the ability of taxable bond issuers to repay loans. These agencies assign credit ratings ranging from Aaa or AAA (highest quality) to C or D (lowest quality).

When considering a fund’s credit quality, most investors should be looking for those that hold ‘investment grade’ bonds, that is, Baa or BBB and above.

Yield to maturity
A fund’s yield to maturity can be thought of as its expected annualised return if all bonds in the portfolio were held to maturity. However, as the fund will generally need to sell bonds before they reach maturity in order to maintain the portfolio allocation, it won’t be the exact return you receive but it can provide a good guide.

Effective duration
This measurement can be also used to estimate how much the value of a bond fund may rise or fall in response to a change in interest rates. The higher the duration, the more dramatic the response can be. This is where your risk tolerance level or risk profile can assist in fund selection.

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Bond credit ratings

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.

Moody’s and Standard & Poor’s bond rating codes

Moody’s

S&P

Rating

Investment-Grade Bonds

Aaa

AAA

Highest quality with lowest risk; issuers are exceptionally stable and dependable.

Aa

AA

High quality, slightly higher degree of long-term risk.

A

A

High-medium quality, many strong attributes but somewhat vulnerable to changing economic conditions.

Baa

BBB

Medium quality, adequate but less reliable over the long term.

Below Investment-Grade Bonds

Ba

BB

Somewhat speculative, moderate security but not well safeguarded.

B

B

Low quality, future default risk.

Caa

CCC

Poor quality, clear danger of default.

Ca

CC

Highly speculative, often in default.

C

C

Lowest rating, poor prospects of repayment.

 

D

In default.

 Source: Standard & Poor's and Moody's Investor Services

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