Business, Legal & Accounting Glossary
Fixed Income is a type of investment yielding a fixed rate of interest in the form of a coupon. Corporate Bonds, Governments Bonds, Guaranteed investment contracts (GICs), High Yield Bonds, Municipal Bonds, are some of the types of fixed income securities. The rate of interest and term are often fixed.
The term “fixed income” means a sort of investment that can not be classified as an equity position, but which provides an obligation to the issuer or borrower to pay against it on a set schedule. This applies even if there is a variability on the number of payments that must be made.
Fixed income refers to any type of investment that yields a regular (fixed) payment. For example, if you borrow money and have to pay interest once a month, you have issued a fixed income security. When a company does this, it is called a bond (although ‘preferred stock’ is also sometimes considered to be fixed income).
The term fixed income is also applied to people’s income which are invariant each period. This could include income derived from fixed-income investments such as bonds and preferred stocks or pensions that guarantee a fixed income.
Fixed-income securities can be contrasted with variable return securities such as stocks. To understand the difference between stocks and bonds, you have to understand a company’s motivation. A company wants to raise money, and it doesn’t want to wait until it has gotten enough through regular operations (selling products or providing services). In order for a company to grow as a business, it must raise money. Investors will only give money to the company if they believe that they will be given something in return. The company can either pledge a part of itself, by giving equity in the company (stock), or the company can give a promise to pay regular interest and borrow the money (bond).
While a bond is simply a promise to pay interest on borrowed money, there is some important terminology used by the fixed income industry:
People that invest 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, but not use up their money. 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, the person will have their money returned to them.
Interest rates change over time. For example, if a company wants to raise $1 million and not a lot of people in the market have free cash to lend, the company will have to offer a high rate of interest (coupon) to get people to buy their bond. If there are a lot of people in the market trying to get a return on their money, the company can offer a lower coupon.
To complicate matters further, fixed income securities are actually traded on the open market, just like stocks. To understand this, first realize that bonds are usually traded in certain amounts, for example, $100,000. If you want to receive 7,000 a month and the going interest rate is only 6%, you will have to pay a premium to get the amount you want. Likewise, if you need only 5,000 a month, you can get that bond at a discount.
One example of this is if an individual were to lend a borrower money which requires the borrower to pay a level of interest each month. This constitutes being issued a security that has fixed income. Other examples of this abound, including the governments which issue government bonds in the currency of their nation and what are known as sovereign bonds in the currencies of other nations. Another example is that of the local government, which finances itself through the issuance of what is known as a municipal or “muni” bond. Agency bonds are the type of debt that is issued through an agency of a government body. Corporate bonds are the type that is issued by a company, and sometimes these types of bonds are used to get a corporate loan from a bank. There are even corporate instances in which the issuance of preferred shares of stock fall into the fixed income category. The lending on a securitized basis that banks often do through mortgages, car notes and the debt associated with credit cards can be reformed and pooled together into fixed income types of products such as the ABS or asset-backed security. These are a type of security which can be traded in the same method as a government bond or a corporate bond, and often is on many kinds of exchanges.
Use of the term fixed income can also be applied to the income of an individual if it does not change with any given period. In some cases, this type of fixed income will include that which is derived from investments that pay fixed income levels, including that of preferred shares of stock, bonds and a pension in which a guaranteed level of income is set. If a retiree or a pensioner is dependent on such a source of income as their dominant form, the term fixed income also puts forth an implication that there is a fairly small level of income the individual can use for discretionary purposes or any type of larger expense items. This is a term that often implies a tiny degree of financial freedom.
The securities that are classified as fixed income are able to be contrasted against securities with equity because the latter often carry no need to pay a dividend. Many stocks never pay one. So that a company can grow its business interests to the maximum extent possible, the raising of money is often necessitated. The reasons money may be necessary are myriad, such as to purchase equipment and land, putting money into the development of new products and even to buy other businesses, known as making acquisitions. An investor is expected to give money to companies only on the reasonable provision that there is a solid belief that the company will provide the investor with something of commensurate value given the level of risk the investor is taking on in this instance. A company is able to pledge a partial degree of ownership in itself through the dividing up of equity through the issuance of stock, or it can just as well pay a level of interest on the amount invested along with partial payments against the original principal amount. Examples of the latter include the issuance of preferred stock, bonds or bank loans.
The portion of “fixed income” that is fixed tends to refer to the obligation to repay the principal amount on a fixed schedule, as opposed to the amount that is actually due. There are examples of securities that offer fixed income, and these include things such as variable interest notes where the rate can change, bonds linked to inflation and inflation-protected securities. In the event that such a security’s issuer ever fails to pay on the security issued, this is known as being in default. In this type of instance, the payees to whom the issuer owes the money are able to force the individual or company into bankruptcy. By contrast with this, there is neither a default involved nor any type of violation present in any type of covenant of payment if a company does not pay any dividend on the shares of common stock it has issued.
Even though a bond carries little more than a promise for the payment of some degree of interest on money borrowed, some terms are important and are used frequently within the industry related to fixed income securities.
For example, the entity that borrows some amount of money and thus issues a bond and agrees to pay interest on it is known as the issuer of said bond.
The bond features an amount that the issuer originally borrowed and that must be paid back to the lender at some point. This amount of money features several different names, such as the par value, the face value, the maturity value or the principal amount.
The level of interest that must be paid back by the issuer is known as the bond’s coupon.
At some point, the bond will expire. At this point, the issuer is obligated to repay the principal amount of the bond. This time is known as the maturity of the bond.
The bond is also known as the issue because of the act of issuing the bond in the first place.
There is a special name for the contract which forms up the rules and the terms associated with a particular bond issuance. This contract is known as the indenture.
The individuals and other entities who invest their money into securities that pay a level of fixed income typically do so because they are looking for a reasonably secure and constant level of return on the money they have invested. Some examples of this include retired individuals who would prefer the dependability of the payments in order to have money to support their lifestyle without having to spend the principal amount. Such an individual can purchase bonds using their money, and then they can live on the interest or the coupon payment as their regular source of income. Using the refinance of the bond or upon the date of its maturity, such a person will simply get back their original investment.
The investments that pay a level of fixed income in the variety of bonds or loans are often priced according to what is known as the credit spread above a reference rate of interest that carries a low level of risk. Some of the more commonly known examples of low-risk level interest rates are German bonds, U.S. Treasury bonds and LIBOR. The main way to equate one interest rate to another is by ensuring that the duration of the two notes is the same. One easy example of this is if a mortgage with a duration of 30 years carries a 5 per cent interest rate while a 30 year Treasury note pays a 3 per cent yield, the yield differential or the credit spread would be 2 percentage points. The level of the credit spread reflects the level of risk that such a group may go into default, and also has to carry some level of profit for the lenders themselves, while other factors may also be reflected within the lower risk rate that is used as a reference point. The rates of return that are paid by essentially riskfree types of notes change with the times and are affected by numerous different factors, and many of these are set up by the central bank rates from groups like the Federal Reserve in the United States, the Bank of England within the UK and the ECB in the Euro Zone. If the prevailing level of interest is higher than that of the coupon for a given bond, the price of said bond rises. By contrast with this, the price tends to rise when the general low-risk interest rate makes the coupon on a bond higher by comparison.
When an individual buys a bond, they or essentially purchasing the cash flow over time that the bond will produce. This level of cash flow is presented at a discount based upon the perception by the buyer of how the rates of exchange and interest are likely to move during the life of the bond.
The prices of bonds tend to be affected by factors such as the combination of demand and supply of said. This is particularly the case for participants within the market that are constrained by what types of investments they may make. For example, there are long term liabilities that an insurance company would prefer to have a hedge against, and this tends to require such a predictable and low-risk alternative like bonds issued by a government across a long duration.
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This glossary post was last updated: 26th April, 2020 | 3 Views.