What is the fixed income asset class?

Fixed income refers to debt instruments that deliver a steady stream of cash to investors. The asset class is composed of bonds issued by companies, governments and other entities. The issuer borrows a fixed amount of money (the principal) over a set time frame and promises to pay the lender back in full at the end of that period. In the intervening period, the issuer makes interest payments (known as coupons) to the lender at regular intervals – often quarterly – and at a rate fixed when the bond is issued. So, the lender receives a ‘fixed income’ as compensation for the risk involved in lending the money. There are some bonds that offer a variable interest rate, or where the interest rate on the principal is linked to a specific measure of inflation.

The fixed income asset class tends to be less volatile than equities, but the potential for capital gains is also generally lower over the long term. Government bonds, especially those issued by leading and politically stable economies, are among the least risky instruments in the world. Indeed, US Treasuries – bonds issued by the US government – are considered to be the safest instrument in the world.

Bonds issued by high-quality, stable companies (termed ‘investment grade’) follow government bonds in the risk spectrum. High-yield bonds, colloquially known as ‘junk’ bonds, comprise the riskiest area of the fixed income sector.

The long and the short of fixed income

The fixed income sector is divided into short-term bonds (issued over one to three years) and long-term bonds (which mature over 10 to 30 years, or sometimes longer). Short-term bonds are characterised by lower risk exposure, better liquidity, and less impact from interest-rate fluctuations than is the case with long-term bonds.

The ratings game

The creditworthiness of borrowers is analysed by ratings agencies. They analyse the financial health of the issuer and its ability to repay the loans, and then assign a rating to that issuer. The most creditworthy issuers receive a triple-A score, while the lowest receive a D. The rating determines the interest rate the borrower will have to pay, the lowest-rated issuers paying the highest interest rate as they are deemed the riskiest fixed income investments.

The second-hand market

While investors can hold bonds from the time they are issued to the date when they mature and the debt is repaid, a secondary market has developed to allow investors to sell or buy into bonds after they are issued. Many factors influence the price of bonds on the secondary market, from macroeconomic factors such as the general level of interest rates to changes in the fortunes of the underlying issuer.

For example, if interest rates rise, the fixed income offered by a bond may seem less attractive than when it was first issued. Consequently, investors are more likely to buy the bond if its price falls. That would make the fixed income offered by the bonds more attractive in percentage terms.

Take the example of a bond issued at a price of £100 and paying a coupon of £5 per annum, or a yield of 5%. If interest rates stood at 3% when the bond was issued, that yield would appear attractive to investors. But if interest rates subsequently rise to 5%, the price of the bond on the secondary market would have to fall to, say, £85 (meaning the £5 coupon would provide a yield of 5.9%) to attract investors.

That example highlights the relationship between prices and yields: namely, they always move in opposite directions. When bond prices rise, yields fall, and vice versa.