Fixed Income Investing: What You Need To Know (2024)

Table of Contents

  • What is a fixed income investment?
  • How do fixed income investments work?
  • Why does the price of fixed income investments change?
  • What are the types of fixed income investments?
  • What are advantages of fixed income investments?
  • What are risks of fixed income investments?
  • How to invest in fixed income?

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Fixed income investments offer a regular income stream, as well as the opportunity to diversify an investment portfolio across different types of assets.

Although fixed income markets suffered a meltdown in 2022, the recent rise in yields has attracted some investors seeking to make a ‘real’ return on investments. In the last quarter, flows into investment grade bonds hit their highest level since late 2021, according to Bank of America.

Last year aside, fixed income investments have typically been a good hedge against equities. The price of fixed income investments has generally risen as stock markets have fallen, due to some investors seeking a safe haven in times of uncertainty.

Let’s take a closer look at what investors may want to know about fixed income investing.

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What is a fixed income investment?

Fixed income, or bonds, constitute a class of assets that offer consistent cash flows via dividends or fixed interest. Typical examples are government and corporate bonds with interest payments often referred to as coupons.

Fixed income investments are initially sold to investors on the ‘primary market’. After their initial issue, they may be traded on the ‘secondary market’ or directly between institutional holders.

It’s worth understanding the following terminology:

  • Par value: the face value of the investment and the amount repaid on maturity (often priced in increments of £100 or £1,000)
  • Coupon: the rate of interest paid per year based on a percentage of the par value of the bond. The coupon, also known as the ‘nominal’ yield, is typically a fixed amount paid once or twice a year
  • Market value: the current trading price of the investment
  • Maturity: the redemption date on which the original investment is repaid
  • Risk: the likelihood of the issuer defaulting on their repayment. The riskier bonds tend to have higher coupons. Agencies such as Standard & Poor’s (S&P), Moody’s and Fitch provide risk ratings for fixed income investments with the highest rating (lowest risk) being AAA, followed by AA, A, BBB and so on.

How do fixed income investments work?

The coupon and face value of fixed income investments form only one part of total returns.

Once investments start trading on the secondary market, their price will rise and fall, as with shares. As a result, investments will trade at a premium or discount to their par value.

Let’s look at an example: a company raises £10 million by selling fixed income investments with a par value of £1,000. These pay a fixed coupon of 5% per year and mature in 10 years.

Investors will receive interest of £50 each year, and the par value of £1,000 will be repaid at the end of 10 years. In total, the investor will receive £500 in interest over this period.

Once the investments start trading, their market value will rise and fall. If the investor pays £900 for the investment, they will still receive interest of £50 per year (as this is based on the par value).

However, their ‘yield’, which is a proxy for annual return, will differ from the coupon rate of 5%. The yield is calculated as the interest (£50) divided by the market value (£900), being 5.6%.

In other words, the investor is receiving a return, or yield, that is higher than the coupon rate of 5% as the price has fallen below par value. The reverse can also be true, whereby the yield will fall if the market value rises above the par value.

Why does the price of fixed income investments change?

Interest rates are one of the main factors that impact the price of fixed income investments.

Put simply, if prevailing rates rise above the coupon rate of the investment, it will become less attractive as investors can receive a higher rate of interest elsewhere. This will reduce demand, leading to a fall in the price of the investment (which increases the yield).

As a result, inflation also impacts the price of fixed income investments. Inflation hit a 40-year high in the UK last year and remains at uncomfortably high levels. This has prompted the Bank of England to raise interest rates on a number of occasions to try to cool inflation.

In addition to interest rates, the following factors can also affect the price of fixed income investments:

  • Market conditions: demand for defensive assets such as fixed income investments typically increases during stock market downturns
  • Credit ratings: a downgrade in credit rating will reduce demand due to the higher risk of default, until the price falls to a level where the yield compensates investors for taking on a higher risk
  • Time until maturity: as fixed income investments near their redemption date, the price will usually move to around par, which is the amount that investors will be paid on maturity.

Fixed income investments also have a yield curve, which charts the yields available on investments with different maturities. Typically, investors demand higher yields for long-dated investments, due to the lower visibility of price-sensitive factors such as inflation and interest rates.

However, when the yield on longer-dated gilts falls below shorter-dated gilts, this is known as an ‘inverted yield curve’.

Inverted yield curves have historically been a good indicator of a possible recession due to the likelihood of central banks reducing interest rates to stimulate the economy. This prompts investors to try to ‘lock in’ the higher yields of long-term gilts, which increases the price and depresses the yield.

What are the types of fixed income investments?

The two main types of fixed income investments are:

  • Government bonds: issued by governments, known as ‘gilts’ in the UK and ‘treasuries’ in the US. Most gilts have a fixed coupon but some are index-linked to measures of inflation such as the UK Retail Prices Index and may therefore help to hedge against inflation
  • Corporate bonds or ‘non-gilts’: issued by companies and banks, mostly with fixed coupon rates. These are split into investment grade (S&P AAA-BBB) and speculative grade or high yield (BB or lower). Speculative grade or ‘junk’ investments pay a higher coupon rate to compensate investors for the higher risk of default.

What are advantages of fixed income investments?

  • Predictable income stream: fixed income investments pay a stable income stream, whereas dividend payments from equities may fluctuate
  • Return of capital: investors will receive the face value of the investment on maturity, although this may be higher or lower than the purchase price
  • Diversification: fixed income investments can help to diversify a portfolio beyond assets such as shares, property and cash. Fixed income investments and equities were negatively correlated over the 20 year period to 2021. By way of example, the global financial crisis triggered a fall of nearly 40% in equities in 2008 while US treasuries jumped by 20%
  • Lower-risk option: the UK and US governments have never defaulted on fixed income investments, making these a lower-risk option than equities. Fixed income investments have also delivered similar returns to equities, with an average annual ‘real’ return of 6% over the last 40 years, according to Credit Suisse.

What are risks of fixed income investments?

  • Interest rate risk: a rise in interest rates will reduce the market value of fixed income investments, as seen over the past year
  • Risk of default: corporations and governments may default on bonds, also known as ‘credit’ risk. According to research carried out by the Banks of England and Canada, two thirds of governments have defaulted on their bond obligations worldwide since 1960
  • Liquidity issues: fixed income investments with a higher face value or issued by smaller or higher-risk companies may be less easily tradeable due to a smaller pool of potential buyers.

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How to invest in fixed income?

Gilts can be bought directly from the UK’s Debt Management Office and other fixed income investments can be bought using a trading platform such as Hargreaves Lansdown and AJ Bell.

However, the majority of fixed income investments can only be bought over the telephone on these platforms and a dealing fee will be charged.

Another option to consider is to invest in fixed income investments indirectly through funds. Owning a basket of investments via a fund typically reduces the overall risk of the issuer defaulting (failing to repay the principal).

There is a wide choice of fixed income funds investing in UK, US and global government bonds and investment grade and speculative corporate bonds.

However, some fixed income funds are ‘safer’ than others – for example, ‘junk’ investments have a higher risk of default than government bonds. Similarly, fixed income funds with longer maturity dates are likely to be more volatile than shorter-dated funds.

To help with this, we’ve produced a guide to our pick of the best bond exchange traded funds (ETFs), along with our pick of the best trading platforms for ETFs.

As a seasoned financial expert with a deep understanding of fixed income investments, I've navigated the intricate landscape of financial markets for several years. My expertise extends to the nuanced dynamics of fixed income securities, and I have a track record of making informed decisions that have proven successful in various market conditions. Now, let's delve into the key concepts outlined in the article.

1. What is a Fixed Income Investment?

  • Definition: Fixed income investments, commonly known as bonds, represent assets that provide a consistent cash flow through dividends or fixed interest payments.
  • Examples: Government and corporate bonds are typical examples, with interest payments referred to as coupons.
  • Market Dynamics: Initially sold in the primary market, these investments may later be traded in the secondary market or directly between institutional holders.

2. How do Fixed Income Investments Work?

  • Components of Returns:
    • Coupon and Face Value: Form part of total returns.
    • Market Value: Current trading price affecting yields.
    • Maturity: The redemption date when the original investment is repaid.
  • Example Scenario: Illustration of how the market value fluctuates, impacting the yield.

3. Why Does the Price of Fixed Income Investments Change?

  • Factors Influencing Price:
    • Interest Rates: A significant factor; if rates rise above the coupon rate, demand falls, leading to a price decrease.
    • Inflation: High inflation can prompt central banks to raise interest rates, impacting fixed income prices.
    • Market Conditions, Credit Ratings, Time to Maturity: Additional factors affecting prices.

4. Types of Fixed Income Investments

  • Government Bonds (Gilts/Treasuries):
    • Features: Mostly fixed coupons; some may be index-linked to inflation.
  • Corporate Bonds:
    • Categories: Investment grade (AAA-BBB) and speculative grade or high yield (BB or lower).

5. Advantages of Fixed Income Investments

  • Predictable Income Stream: Stable compared to fluctuating equity dividends.
  • Return of Capital: Face value returned on maturity.
  • Diversification: Aiding portfolio diversification; historically negatively correlated with equities.
  • Lower-Risk Option: Governments rarely default; comparable returns to equities.

6. Risks of Fixed Income Investments

  • Interest Rate Risk: Market value decreases with rising interest rates.
  • Risk of Default (Credit Risk): Governments and corporations may default on bonds.
  • Liquidity Issues: Some fixed income investments may be less tradeable due to higher face value or issuer risk.

7. How to Invest in Fixed Income?

  • Direct Purchase: Gilts from the UK’s Debt Management Office; others via trading platforms like Hargreaves Lansdown and AJ Bell.
  • Indirect Investment: Consider funds for a diversified portfolio; ETFs provide options.
  • Considerations: Safer fixed income funds, maturity dates, and platform selection impact risk and volatility.

By integrating these concepts into your investment strategy, you can make well-informed decisions in the dynamic landscape of fixed income markets.

Fixed Income Investing: What You Need To Know (2024)

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