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Fixed Income

TL;DR

  • Fixed Income refers to fixed income encompasses securities that pay a fixed amount of interest at a fixed time - such as government and corporate bonds, and includes the broad class of interest-bearing securities like swaps

  • Fixed Income instruments provide known future cash flows at a specific date (maturity).

  • Such investments are less risky but also provide a lower return


What is Fixed Income?

As the term says, fixed income encompasses securities that pay a fixed amount of interest at a fixed time to an investor/holder of a fixed income security. The investment horizon of a fixed income security is called “time to maturity” and at maturity, investors are repaid their entire initial investment, in addition to the interest they received on the initial investment. Unlike equity, where the future payments are unknown, fixed income securities provide a steady flow of fixed cash flows based on interest rates or dividends, which are both known in advance.


In the event of a bankruptcy, fixed income investors receive priority over common stockholders for repayment. Hence, investing in fixed income securities are less risky but provide a lower return than equity investments. The most common types of fixed incomes securities are government and corporate bonds.


What is a Bond?


Similar to how a company introduces equity to aid their business operations, companies and governments issue debt securities to finance operations. A bond is a debt security and type

of fixed income security that pays the holder their initial investment amount, with interest, on the maturity date.


Example: Armenak buys a corporate bond from ABZ Bank. They issue a $10,000 bond with a 10 year maturity at 5% “coupon rate.” So Armenak must first pay the bank $10,000 to buy the bond. After that, he will be paid interest payments overtime (aka coupon payments), on an annual basis and calculated like this: $10,000 * 5% = $500 every year for 10 years. At the maturity date, Armenak will receive his initial $10,000 investment. Therefore, in total, Armenak would have made $5,000 from 10 yearly coupon payments of $500 each and the repayment of his initial investment.


Seeing as the above mentioned example is in regards to a corporate bond, Armenak received a higher coupon rate than if he would have bought a government issue bond. This is because a corporate bond entails some risk and therefore investors must be compensated extra for that additional risk. On the other hand, a government bond is backed by the guarantee of repayment by the government (pretty credible source right).


On top of the difference in cash flows, another difference between a bond and stock is that a bond does not entail any form of ownership in the parent company.