How Fixed Income Works
This short guide explains how fixed income securities (or bonds as they are also known) work and how they can fit into your portfolio. It aims to provide you with a better understanding of why fixed income is an important asset for preserving capital and achieving a steady income.
What is a Bond?
One way a government (treasury bonds) or a company (corporate bonds) can borrow the money they need to fund their projects or initiatives is to issue bonds.
The word “bond” means contract, agreement or guarantee. Each of these terms applies to the financial securities known as bonds, which are simply agreements to borrow money and then repay it (in addition to regular interest payments) after a fixed term.
In other words, a bond is a loan issued by the borrower (issuer) and purchased by the lender (investor). The borrower in turn makes two key promises to the lender:
1. To repay the capital on a predetermined date (known as maturity).
2. To pay regular interest payments throughout the life of the loan (at the “coupon” rate).
Looking at the payment, you can see why bonds are also referred to as “fixed income” securities. They provide investors with a return in the form of fixed regular payments (coupon) and the repayment of the principal (initial investment) on maturity. So far, we have discussed the primary markets for bonds, where new bonds are created (issued) and bought by investors. Once they have been issued, investors can buy and sell bonds on the secondary market. However, they are generally not traded on an exchange (like shares) and are bought/sold over the counter (OTC) with high minimum investment thresholds (typically $500,000). This means the typical investor usually accesses bonds via a professionally managed investment fund.
Characteristics of a Fixed Income
Fixed income is an asset class that tends to be used in the defensive part of investors’ portfolios. The asset class primarily consists of debt securities, which are financial assets created when one party lends money to another.
Types of debt securities include government bonds, municipal bonds, corporate bonds and asset-backed securities such as mortgage-backed bonds.
Fixed-income investing can potentially offer investors benefits such as assets with a focus on capital preservation, income generation and diversification. Government bonds are also highly liquid, meaning they can be sold for cash quickly and at a low cost.
Advantages:
Security – Bonds provide a degree of certainty that the full principal will be repaid at maturity.
Regular Income – For investors who need a predictable source of income, such as retirees, a bond’s regular interest payment can provide greater certainty than other investments.
Performance – A better interest rate may be available from some bonds, such as corporate bonds, than from other investments (like term deposits).
Diversification – Because bonds tend not to move in tandem with stocks, they help provide diversification in an investor’s portfolio.
Here at Pass Investment Managers we understand that every individual has different priorities in life, and very specific goals and objectives, which are reflected in the way each of us organizes our finances.
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