Bond Education – An Introduction to Fixed Income
If you feel that the investing world is becoming increasingly fast paced and complex, there is a segment of the market known for its relative stability. Fixed income is an asset class that can help investors preserve capital, generate regular income, and access potential capital growth. This article will take you through the basics of fixed income, its key components, and why it may suit your investment goals.
Why are bonds known as fixed income investments?
In the equity market, companies issue shares, which give investors partial ownership of a firm. By contrast, fixed income investments – typically bonds issued by governments and companies – allow investors to lend money to the issuer for a set period (such as two, 10, or even 30 years). In return, investors receive regular interest payments and the return of the original principal amount of the loan (also known as its face value) at the end of the bond’s life (or its maturity).
Examples of bond issuers
Source: PIMCO. For illustrative purposes only.
Bonds pay the lender a set interest rate (or income), also known as the bond’s coupon, at regular intervals throughout its life – quarterly, semi-annually, or annually. This predictable payment schedule is what defines ‘fixed income’.
At the bond’s maturity date, the investor receives the bond’s face value. For example, a government or a company might issue a 10-year bond with a face value of $1,000, paying an annual coupon of 5% at issuance. The investor pays $1,000 to purchase the bond, receives $50 in coupon payments each year, and, assuming there are no defaults, gets the original face value of $1,000 back at maturity.
Bonds usually provide lenders with interest that the borrower pays
Source: PIMCO. For illustrative purposes only. There is no assurance that it will achieve its investment objective or that the stated results will be achieved.
How to calculate a bond’s value
However, that is only part of the picture. Bonds can be traded before they reach maturity, and their market prices fluctuate, just like stocks and shares. When a bond looks more attractive to investors, its market price will rise. This is where the concept of yield comes into play – yield represents the actual return you receive for lending your money.
While the coupon remains fixed, the yield fluctuates depending on how the bond’s market price changes. When a bond’s price rises, its yield declines – because paying more for a $1,000 bond makes the fixed coupon payment relatively less valuable. Conversely, purchasing a bond below its face value increases your effective yield.
In short, yield indicates the income and overall return you will earn from a bond, depending on the price you pay for it and how long you hold it.
Bond prices are inversely related to interest rates
Source: PIMCO. For illustrative purposes only.
Investment factors to consider
One key factor affecting bond prices is interest rates. For example, when a central bank like the U.S. Federal Reserve raises interest rates, any new Treasury bonds issued by the U.S. government would offer higher coupons, making existing bonds with lower coupons less attractive – so their prices fall. Conversely, when interest rates fall, older bonds with higher coupons become more appealing and so their prices rise. This inverse relationship is why bond prices and interest rates typically move in opposite directions.
Inflation can erode the real value of future bond payments, pushing prices down. The issuer’s credit quality, essentially the likelihood that the borrower issuing the bond will repay its debts on time, is also a factor. If a government or company is viewed as a higher risk investment, its credit rating may deteriorate, leading to a drop in the market price of its bonds. Additionally, longer-term bonds tend to be more sensitive to interest rate changes, and investor demand can also influence prices.
For investors who hold bonds to maturity, price fluctuations are less relevant, as long as the issuer meets its payment obligations.
All bond investors, however, must consider the risk of default. Although rare, this occurs when the bond issuer is unable to pay either the face value or the coupon when due. In the event of bankruptcy or liquidation, bondholders have a higher claim on assets than shareholders.
Investment risks bond investors may face
No investment is entirely risk-free, and that includes the fixed income market. However, bonds are generally considered less risky than equities because they represent loans that the issuers are legally obligated to repay. In contrast, stocks and shares offer no such repayment assurance.
Why consider the bond market?
Fixed income allocations may offer multiple benefits to a portfolio
Source: PIMCO. For illustrative purposes only.
During periods of market uncertainty, investors often reduce exposure to riskier assets like equities and may shift toward fixed income, which is generally viewed as a more stable component of a diversified portfolio. Including bonds in a balanced portfolio can help manage risk while providing potential benefits such as income, capital preservation, and investment diversification.
How do I invest in bonds?
Bond investors can choose from many different investment strategies, depending on the role or roles that bonds will play in their investment portfolios. Investors may buy bonds directly through a brokerage account, a government distribution channel, or an electronic trading platform. Alternatively, they can invest in specialist bond funds managed by asset management firms. Meanwhile, a growing number of market participants are selecting exchange-traded funds (ETFs), which are traded daily in various global markets. Bond funds and ETFs usually invest in a variety of bonds, such as corporate, Treasury, or high yield bonds. For a low investment minimum ranging from a few hundred to a few thousand dollars, bond funds allow individuals to invest in a whole range of bonds, managed by professional investment managers.
