Fixed income
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Fixed income refers to any type of
For a company to grow its business, it often must raise money – for example, to finance an acquisition; buy equipment or land, or invest in new product development. The terms on which investors will finance the company will depend on the risk profile of the company. The company can give up
The term "fixed" in "fixed income" refers to both the schedule of obligatory payments and the amount. "Fixed income securities" can be distinguished from inflation-indexed bonds, variable-interest rate notes, and the like. If an issuer misses a payment on fixed income security, the issuer is in default, and depending on the relevant law and the structure of the security, the payees may be able to force the issuer into bankruptcy. In contrast, if a company misses a quarterly dividend to stock (non-fixed-income) shareholders, there is no violation of any payment covenant and no default.
The term "fixed income" is also applied to a person's income that does not vary materially over time. This can include income derived from fixed-income investments such as bonds and
Types of borrowers
Governments issue
Terminology
Some of the terminology used in connection with these investments is:
- The issuer is the entity (company or government) who borrows the money by issuing the bond, and is due to pay interest and repay capital in due course.
- The principal of a bond – also known as maturity value, face value, par value – is the amount that the issuer borrows which must be repaid to the lender.[2]
- The coupon(of a bond) is the annual interest that the issuer must pay, expressed as a percentage of the principal.
- The maturity is the end of the bond, the date that the issuer must return the principal.
- The issue is another term for the bond itself.
- The indenture, in some cases, is the contract that states all of the terms of the bond.
Investors
Investors in fixed-income securities are typically looking for a constant and secure return on their investment. For example, a retired person might like to receive a regular dependable payment to live on like gratuity, but not consume principal. This person can buy a bond with their money and use the coupon payment (the interest) as that regular dependable payment. When the bond matures or is refinanced, the person will have their money returned to them. The major investors in fixed-income securities are institutional investors, such as pension plans, mutual funds, hedge funds, sovereign wealth funds, endowments, insurance companies and others.[3]
Pricing factors
The main number which is used to assess the value of the bond is the gross
In buying a bond, one is buying a set of cash flows, which are discounted according to the buyer's perception of how interest and exchange rates will move over its life.
Supply and demand affect prices, especially in the case of market participants who are constrained in the investments they make. Insurance companies and pension funds usually have long term liabilities that they wish to hedge, which requires low risk, predictable cash flows, such as long dated government bonds.
Some fixed-income securities, such as mortgage-backed securities, have unique characteristics, such as prepayments, which impact their pricing.[4]
Inflation-linked bonds
There are also
Derivatives
Fixed income derivatives include interest rate derivatives and credit derivatives. Often inflation derivatives are also included into this definition. There is a wide range of fixed income derivative products: options, swaps, futures contracts as well as forward contracts. The most widely traded kinds are:
- Credit default swaps
- Interest rate swaps
- Inflation swaps
- Bond futures on 2/10/30-year government bonds
- Interest rate futures on 90-day interbank interest rates
- Forward rate agreements
Risks
Fixed income securities have risks that may include but are not limited to the following, many of which are synonymous, mutually exclusive, or related:
- inflation risk – that the buying power of the principal and interest payments will decline during the term of the security
- interest rate risk – that overall interest rates will change from the levels available when the security is sold, causing an opportunity cost
- currency risk – that exchange rates with other currencies will change during the security's term, causing loss of buying power in other countries
- default risk– that the issuer will be unable to pay the scheduled interest payments or principal repayment due to financial hardship or otherwise
- reinvestment risk – that the purchaser will be unable to purchase another security of similar return upon the expiration of the current security
- liquidity risk – that the buyer will require the principal funds for another purpose on short notice, prior to the expiration of the security, and be unable to exchange the security for cash in the required time period without loss of fair value
- call risk - that the issuer will redeem or call back a fixed-income security before its maturity date, which can result in the investor receiving the principal earlier than expected and potentially at a lower interest rate or price
- duration risk
- convexity risk
- credit quality risk
- political risk – that governmental actions will cause the owner to lose the benefits of the security
- tax adjustment risk
- market risk – the risk of market-wide changes affecting the value of the security
- event risk – the risk that externalities will cause the owner to lose the benefits of the security
See also
References
- ^ Lemke and Lins, Soft Dollars and Other Trading Activities, §§ 2:39 to 2:41 (Thomson West, 2014–2015 ed.).
- ^ "Glossary of Bond Terms". FINRA. 2011. Archived from the original on 2011-07-20. Retrieved 2010-03-07.
- ^ Lemke and Lins, Soft Dollars and Other Trading Activities, Ch. 2 (Thomson West, 2014–2015 ed.).
- ^ Lemke and Lins, Mortgage-Backed Securities, § 5:12 (Thomson West, 2014–2015 ed.).