Bond Education – Types of Fixed Income
Many investors are instinctively drawn to equity markets, given the relative simplicity of the proposition: you buy shares in a listed company and hope to sell them at a profit. In the fixed income market, you aim to grow your money by purchasing debt issued not only by companies, but also by governments and other entities.
This article explores the main types of issuers in the fixed income market. There are four main segments of fixed income issuers:
- Government bonds (also known as sovereign bonds): issued by national or local governments
- Quasi-government bonds: issued by government-related agencies
- Securitised bonds: backed by pools of financial assets such as mortgages or loans
- Corporate bonds: issued by companies
Investors want compensation for taking on more risk
Government bonds
Developed market bonds
Governments in developed markets (DM), such as the U.S., Europe, Japan, Hong Kong, Australia, and Singapore, issue bonds to raise capital for their spending needs. These range from infrastructure development, such as new roads or railways, to investment in social programmes. These bonds are generally considered lower-risk investments because the size of developed economies means their governments typically have a strong ability to meet their debt obligations.
Emerging market bonds
Emerging market (EM) bonds are issued by governments in less developed countries. These bonds carry a higher level of risk because the economies are less mature and lack the depth of DMs. That said, the EM bond market is attracting increasing investor interest. It has grown significantly since the 1990s, with EM governments issuing bonds denominated in both local and major foreign currencies (such as U.S. dollars or euros).
Local government bonds
Regional or local governments also issue bonds to finance public projects or cover their general operating expenses. In the U.S., these are more commonly known as municipal bonds and are often used to fund schools, roads, and other public infrastructure.
Quasi-government bonds
Quasi-government bonds are issued by agencies that are linked to the government but operate independently. In a similar vein to government bonds, these agencies use the capital raised to fund spending programmes, such as building new schools or hospitals. Meanwhile, supranational bodies like the World Bank or European Investment Bank that are closely tied to national governments also issue debt, which is considered quasi-governmental.
Some agency bonds are guaranteed by the associated government, while others are not. However, given their close connection to a government, agency bonds are often perceived as relatively secure.
Securitised bonds
Securitised bonds are fixed income instruments backed by pools of financial assets, such as mortgages, auto loans, or credit card receivables. These assets are bundled together and sold to investors as bonds, with payments coming from the cash flows of the underlying loans.
Common types include:
- Mortgage-backed securities (MBS): backed by residential or commercial mortgages
- Asset-backed securities (ABS): backed by consumer loans or leases
- Collateralised loan obligations (CLOs): backed by corporate loans
Securitised bonds can offer attractive yields and diversification benefits, but they also carry risks related to the performance of the underlying assets and the structure of the security itself.
Corporate bonds
When companies want to raise capital for a project, such as the development of a new operating plant or investment in advanced technology, they have the option to issue corporate bonds as an alternative to equity financing.
Like other fixed income securities, corporate bonds typically have a set lifespan and a fixed maturity date. However, investors can also access what are known as ‘callable’ bonds, which contain a provision in their prospectus or contract allowing the issuer to redeem the bond before its scheduled maturity date. If this happens, investors still receive the bond’s face value, but the early redemption could affect their expected yield.
Depending on the company’s size and financial health, its corporate bonds will fall into one of two broad categories: investment grade or speculative grade.
Investment grade bonds
Investment-grade corporate bonds are issued by robust, often well-known companies with strong credit ratings, suggesting a lower likelihood of default. Because they are perceived as lower risk, these companies don’t need to offer high yields or coupons to attract investors.
Speculative grade bonds
Speculative grade bonds, also called high yield or junk bonds, are issued by companies with lower credit quality and higher default risk than investment grade firms. New or less established firms are often considered speculative grade until their business becomes established in the market. To compensate for the higher risk, speculative grade issuers tend to offer higher yields on these bonds.
To help investors understand a company’s risk profile, independent ratings agencies (such as Standard & Poor’s, Fitch and Moody’s) assess each business and assign it a score, such as AAA, BB, or C. These ratings can be upgraded if a firm’s outlook improves, but they can also be downgraded if the quality of the issuer deteriorates.
Source: PIMCO. For illustrative purposes only.
Bond pricing and risk
A bond’s price is influenced by several factors, including its maturity, credit rating (government and quasi-government bonds are also independently rated) and prevailing interest rates. The yield of a bond reflects its income relative to its market price and changes as prices fluctuate.
Corporate bonds are generally considered riskier than government bonds, so they tend to offer higher yields than government bonds of similar maturity.
All bonds carry some risk of default – the chance that the issuer will fail to repay a lender. Default risk varies based on the credit quality of the issuer.
