Fixed Income Definition (With Examples)
Fixed income is a category of investments where an investor is lending money to the issuer and receives a fixed interest payment periodically until the investment matures. At maturity, the original principal amount is returned to the investor.
How Does Fixed Income Work?
The most common features of a fixed income investment are the coupon (interest rate), face value (principal amount), interest payment dates, final maturity, and call provisions if any. A call provision is a provision that allows the issuer to redeem the security prior to its final maturity. In the case of government, municipal, and corporate bonds, investment maturities can range anywhere from one month to 40 years or more.
Fixed income investing is considered more conservative than investing in stocks due to the dependable nature of receiving regular interest payments and a return of principal at maturity.
However, there is risk in fixed income investing.
The most obvious risk is what is known as credit or default risk. Some municipal bonds are insured against default, U.S. Government bonds are backed by the full faith and credit of the United States, and certificates of deposit are insured by the FDIC, but corporate bonds carry no such guarantees. They are backed only by the creditworthiness of the underlying issuer. The healthier a company is financially, the better its ability to pay interest and return principal.
If a company begins to have financial difficulty, the creditworthiness or quality of the debt (bonds) issued by the company can deteriorate. This can result in the market value of the company’s bonds declining (principal erosion). The company may even default, by no longer making its interest payments. In the event of company bankruptcy, bondholders do have a superior claim on the company’s capital than common stockholders. Historically, in the event of liquidation, bondholders would receive something (although frequently it would be much less than their original investment), while stockholders would receive little return of their investment.
Another risk assumed by fixed income investors is interest rate risk. This is the risk that interest rates may rise after investing in a bond or other type of fixed income investment. The relationship between bond prices and interest rates is inverse in that when interest rates rise, the prices of bonds paying lower rates interest will fall. Conversely, when rates fall, bond prices will rise as existing (higher) coupon rates become more attractive to investors seeking higher yield.
Lastly, fixed income investors are subject to inflation risk. If there is inflation, an investor receiving fixed income interest payments will find that the purchasing power of those payments decreases due to rising prices.
Types of Fixed Income
The most common form of fixed income investments are bonds. Bonds are securities issued by corporations, sovereign nations, or states/municipalities.
Bonds issued by the U.S. government are referred to Treasury bonds. These bonds are backed by the full faith and credit of the United States government. Agencies of the U.S. government such as the Federal Home Loan, the Federal Agricultural Mortgage Corporation, or the Government National Mortgage Association, also known as GSE’s (government sponsored enterprises) also issue bonds. While these bonds aren’t explicitly backed by the U.S. government guarantee, they carry an implicit guarantee as the government has a moral obligation to backstop these entities.
Bonds issued by state and local governments are known as municipal bonds. The money these governments receive through the sale of their bonds is used for public works or service projects such as roads and bridges, schools, water and sewer, or economic development. Often, interest on municipal bonds is paid through revenue on the specific project that the bonds are financing. The most attractive feature for investors is that municipal bond interest is exempt from federal income taxes and, typically, income taxes of the issuing state.
Corporations also issue bonds to finance capital expansion, stock buybacks, or acquisitions. Being in the private sector, they have more flexibility in the type of bonds or fixed income investments they issue. Corporate bonds may be convertible to shares of common stock. Corporate bonds can also have adjustable or “floating” interest payments that vary with interest rates, as well as other unique features.
A fixed annuity is also considered a fixed income investment. An annuity is typically a contract issued to an investor by an insurance company. The investor receives a fixed rate of interest for the term of the contract and a regular stream of fixed payments.
Fixed Income Trading
The markets for fixed income securities are much larger, by volume, than that of equity securities (stocks).
Prices of fixed income investments can move based on different factors, including interest rate fluctuations; geopolitical, economic, and issuer-specific events also affect fixed income trading.
Fixed income securities or bonds trade in the bond market, either in a listed market or exchange or in what is known as the over-the-counter (OTC) market.