Introduction to Fixed Income – Everything You Need to Know

Fixed Income represents the largest segment of the financial market. This is where governments, companies and households get financing and can invest their segments. We give you an introduction into the fixed income market: types of assets, most important players, advantages and risks.

What is the Fixed Income Market?

The fixed income market can also be referred to as the debt market. Thus, fixed income assets are nothing more than debt securities. These debt securities are originated whenever one party wants to borrow money and another party is willing to lend that money.

As a result of that transaction, one party will owe money to the other. Therefore, one party will have a debt and the other an asset. The asset is the right to receive that money from the borrow in the future. And that asset can be traded in the fixed income market.

If we as individuals invest in a fixed income fund, we become creditors. We can become creditors to many different economic agents: sovereign governments, regional governments, supranational institutions, multinational companies, small companies and even households.

The debt market is the largest segment of the capital markets. Debt is one of the most common ways for governments, corporations and individuals to get financing. Investors act as creditors and lend them that capital. In return, debtors agree to pay interest and pay back that money in the future.

As investors, there are many types of assets we can invest in. Some of these assets are used on a daily basis, such as bank accounts or term deposits, while others can represent investments that we will hold for multiple decades.

Understanding what the fixed income market is and how it works is useful whether we want to invest in it, or simply better understand the economy and the dynamics the capital markets. Therefore, I will give you an in-depth introduction into the fixed income market.

Types of Fixed Income Assets

Let us analyze the main types of assets traded in the fixed income market. As you will see, although there are many differences between them, they all represent different forms of debt:

Government Bonds

Government bonds form the largest asset market in the world. This is the natural result of governments, especially in developed countries, being heavily indebted. In 2023, US government debt had already surpassed the $30 trillion mark.

Sovereign debt tends to have very low risk of default. After all, in extreme cases, governments can ask the central bank to print money to avoid bankruptcy. In fact, such a practice became known as quantitative easing, even though that was sold to the public as a program to stimulate economic growth.

The risk with asking the central bank to print the money to finance the government is that it creates inflation. This can lead to an increase in the cost of living and, potentially, hyper-inflation and social unrest.

Although most government bonds are not exposed to credit risk, investing in them is by no means risk-free. Credit risk is just one type of risk fixed income securities are exposed to.

A subcategory of government debt would be debt securities issued by regional governments. In this case, credit risk does exist. Some federal states in the United States, such as California, or municipalities, such as Detroit, has defaulted on their debt in the past.

Another major subcategory is debt issued by supranational entities. Some examples of such institutions would be the World Bank, the Bank for International Settlements (the BIS) or the European Union. This debt is usually denominated in hard currencies and considered as safe as government bonds.

Corporate Bonds

Corporate bonds are debt instruments issued by companies and are an essential part of the fixed income market. Most of these companies are of considerable size, and many of them are also listed on the stock exchange.

Corporate debt tends to have higher interest rates than government debt. But the corporate debt market is very heterogeneous. There are companies that are more solvent than many governments, such as Nestlé or Apple. But there is also a lot of corporate debt with very considerable credit risk. For example, the debt of many corporate borrows is considered junk.

In general, corporate debt carries more risk and is less liquid than government debt. This is because it is a smaller market, more fragmented, and central banks are not as supportive.

Inflation-Linked Bonds

Most bonds pay a fixed rate of interest. But there are also bonds whose payments are variable.

Leaving aside those bonds whose interest rate payments fluctuate with the level of interest rates in the economy, known as floating rate bonds and most of which issued by corporations, the most important segment of variable-rate bonds is inflation-linked bonds.

Inflation-linked bonds are usually issued by governments, but a few corporations also issue them to raise financing. The way these bonds work is relatively simple.

Inflation-linked bonds usually have a fixed nominal interest rate, but the amount on which this interest is calculated increases every year with inflation. This means that, if we invest $100,000 in a bond that pays 2% interest, that $100,000 will always get adjusted upward in line with inflation.

Therefore, if inflation in the first year is 5%, our notional amount will become $105,000. Our interest will be 2% of $105,000. This process will be repeated every year until the bond matures. When that happens, we will receive our-inflation adjusted notional amount.

As you can imagine, owning bonds whose values goes up with inflation comes at a cost. The cost is in the form of lower interest than we would receive if we invested normal nominal bonds. The choice between inflation-linked and nominal bonds will depend on our inflation expectations relative to those of the market. You can learn more about inflation-linked bonds here.

Loans

Loans are originated when banks lend money directly to companies, individuals or even governments. This is in contrast with bonds, where it is mostly institutional investors that tend to lend money, not only banks.

Another difference between loans and bonds is that loans tend to be more private. This is because they are often a private transaction between the borrower and the lender or, at most, a group of lenders.

However, loans can also be bought and sold. As a result, it is also possible to invest in them. As retail investors, loans are usually not available to us. Thus, if we want to invest in this part of the fixed income market, we will have to find an investment fund that focuses on loans.

Mortgages and Other Securitized Products

Personal debt, such as mortgages, car loans, and credit card debt, can also be bought and sold. This is done through a process called securitization. It consists of a bank deciding to sell thousands of its loans. To do this, the bank packages these loans into a security, and sells the security.

One of the problems during the 2008 financial crisis was precisely that banks had been selling very risky mortgages as securitized products that theoretically had very low credit risk. Consequently, when things started to go south, large losses appeared where investors had not anticipated.

However, not all securitized products are bad or risky. Many of them are safe and offer attractive returns. It is worth mentioning that most of these securities are originated in the United States, though many European countries also have such instruments.

Bank Deposits

Even though many of us are not aware of it, current accounts and term deposits are also a type of fixed income investment. This is regardless of whether they pay interest or not. Bank deposits are still a form of debt. It is money that the bank owes us as, from a legal point of view, depositing money into a bank means we are lending that money to the bank.

Therefore, bank deposits have some credit risk. If the bank were to default, the government would cover a certain amount. This can be $250,000 in the United States, €100,000 in most Eurozone countries, or £85,000 in the United Kingdom. The rest of our money would have to recovered from the assets that the bank had, meaning that we would probably lose a percentage of our savings. This risk is often ignored by many individuals.

The biggest advantage of having money in the bank is liquidity. That money is usually available immediately. And we do not have to sell anything to get that cash, unlike with other fixed income assets.

Preferred Shares (Hybrid between Bonds and Stocks)

Finally, we also include preferred shares here. Preferred shares are a hybrid instrument, with characteristics of both fixed income and equity securities. Preferred shares are commonly issued in the form of perpetual debt.

Preferred shareholders, similar to bondholders, are entitled to a fixed dividend payment. However, it should be highlighted that this payment is a dividend and not interest. Consequently, if no such payment takes place, the company is not considered to be in default. But to protect the rights of preferred shareholders, no dividends can be paid to common shareholders unless preferred shareholders are receiving their dividends.

In addition to that, in the event of bankruptcy, preferred shareholders would be paid before regular shareholders. Most preferred shareholders have no voting rights to decide how the company is run and capital allocated.

Some preferred shares allow their owners to convert their preferred shares into common shares at a predetermined conversion ratio. This is usually advantageous if the company has grown and become highly profitable, and its stock price has soared as a result.

Advantages of Fixed Income Investments

All these assets offer some advantages relative to other types of investments, and this is an important section of our introduction into fixed income markets:

Liquidity

Many fixed-income instruments, particularly bank deposits and government bonds, are highly liquid. As a result, they are ideal to own if we may need cash in the near future.

Liquidity needs may be motivated by something we have planned in our life, such as the purchase of a property, or by unforeseen events, such as a stock market crash. In any event, there is value in having some dry powder in our investment portfolio.

It should be noted that some fixed income instruments are less liquid than stocks, gold or Bitcoin. For example, most corporate bonds, loans or mortgages may be difficult to sell at a good price in times of financial distress.

Less Risk than Equities

Fixed income assets tend to have less risk than stocks. This is especially true in the short term. While drops of 20% are certainly possible in the fixed income market, we experienced in 2022, they are a lot less common than in the stock market.

As a matter of fact, in times of economic and financial crisis, the safest types of bonds tend to increase in value while everything else is plummeting.

Interest Income

Although interest rates are lower than they were a few decades ago, interest income is still something investors seek. One of the positive aspects of investing in fixed income is that, in general, we know advance how much interest we are going to receive in the future. Hence the name fixed income.

If we buy a bond with a maturity of 10 years and annual interest of 4%, we know that, unless there is a default, we will receive our 4% interest every year.

Inflation Protection

This point is only applicable to inflation-linked bonds. Thanks to the fact that our investment is indexed to the official inflation rate, our money grows with inflation. That protects us against one of the biggest risks that fixed income investment are exposed to: inflation risk.

Of course, these bonds tend to be more expensive and have lower interest rates than those that are not inflation-adjusted. At the same time, there is often criticism around the way the official inflation rate is calculated, as governments are incentivized to underestimate inflation.

As a consequence of that, inflation-linked bonds may be an imperfect way to hedge against the risk of inflation.

Hedge against Recessions and Deflation

When there is a recession, central banks tend to lower interest rates to stimulate the economy. This often causes interest rates on fixed-income instruments, especially the safer ones such as government bonds, to drop as well. When interest rates go down, bond prices go up. If we own these bonds, we will realize a capital gain.

The amount of these gains will depend on the duration of our investments. The further into the future the maturity of our bonds, the more potential to experience gains from a decrease in interest rates. If you want to learn more about duration and the relationship between bond prices and interest rates, check out this post.

In case of deflation, as remote as that may seem, interest rates are most likely going to go down, pushing up bond prices.

Risks of Fixed Income Investments

Next in our introduction to fixed income, we will discuss about the risks we may be taking on by investing in these types of assets:

Credit Risk

Credit risk means that the individual, business, bank, or government that owes us money may be unable to pay it back to us in the future. It is probably the risk that first comes to mind when we think about lending money to someone else.

It should be noted that credit risk is much higher in certain types of fixed income instruments (corporate bonds, loans and personal debts) than in others (government or supranational bonds). A good way to assess credit risk is by looking at the security’s credit ratings.

Interest Rate Risk

When interest rates rise, fixed income instruments see their interest rates go up. And for that to happen, bond prices must fall. The term interest rate risk is used to describe the risk of losses if interest rates increase.

This is especially true for those instruments with longer durations. The further into the future a bond or loan matures, the more interest rate risk it will have. This is the opposite situation of us benefiting from interest rates going down.

Therefore, the higher the duration of our bonds, the more potential for capital gains if interest rates drop, but also the higher risk of capital losses if interest rates go up.

We must emphasize that short-term debt, for example instruments maturing within a few months, have negligible amount of credit risk. And bank accounts have no interest rate risk whatsoever.

Inflation Risk

Inflation is one of the greatest risks of fixed income investing, especially if we are in it for the long term. Inflation is that enemy that makes the value of our money go down.

Because interest rates are usually fixed in advance, an unexpected rise in inflation suddenly makes our investment much less attractive.

That is precisely one of the great problems of investing in fixed income when both inflation and interest rates are very low. A sudden increase in inflation is likely to lead to higher interest rates. Consequently, not only will the value of our money go down due to inflation, but the price of our investment will also go down due to the higher interest rate.

Obviously, inflation-linked bonds are not exposed to inflation risk. If you are worried about the risk of inflation, you can check out which assets tend to be the best ones to own in times of high inflation:
How to Invest for Hyperinflation

Lack of Liquidity

While liquidity is one of the great advantages of having money in the bank, we must be aware that some fixed income instruments can be relatively illiquid. This means buying and selling them is expensive and can take some time.

Such problems are usually more acute in times of financial stress. Precisely when our need for liquidity may be highest. The assets most exposed to illiquidity risk are corporate bonds (the worse their credit quality, the greater the risk), loans and mortgage securities.

Main Fixed Income Investors

Let us finish our introduction into fixed income by discussing who are the main players in this market:

Central Banks

Central banks have long been one of the major players in the fixed income market, particularly when it comes to government bonds. Traditionally, central banks bought and sold treasury bonds to control monetary policy, influence interest rates and affect inflation.

Since the 2008 great financial crisis, however, massive debt purchases by central banks have become the norm to ensure that governments can borrow as much as they want at very low cost. In some regions of the world, such as the Eurozone, negative interest rates were implemented and enforced by the central bank thanks to their role in the fixed income market.

Corporate bonds and mortgage securities can also be bought by central banks. Though this is less common than government bonds.

Commercial and Investment Banks

Banks also invest part of their funds in fixed income instruments. Obviously, banks grant loans and mortgages as part of their day-to-day business. But they also buy and sell bonds to manage their level of credit risk, interest rate risk, as well as to comply with current banking regulations.

Insurance Companies

Insurance companies charge premiums to their clients and promise to pay in the future in certain things happen. Because some of that money will not be needed for many years, it must be invested. And, in most cases, it must be invested conservatively. Therefore, most of it ends up in the fixed income market.

Pension Funds

Pension funds also invest in fixed income assets. Because they are usually limited in terms of how much risk they can take, a substantial percentage of their assets is invested in government and corporate bonds.

Pension funds are an important player in the fixed income markets regardless of whether they manage their assets at an institutional level, or if individual investors manage their pension fund on their own.

Sovereign Wealth Funds

Some countries, usually those that have been blessed with vast amounts of natural resources and are saving some of those proceeds for the future, have large sovereign wealth funds.

For example, Norway, Saudi Arabia, Singapore or Qatar, have sovereign wealth funds that invest money all over the world across different asset classes. Therefore, they are big participants in the fixed income market, and their actions can often move market pricing in a significant manner.

Investment Funds and ETFs

Asset management companies, such as Blackrock, Vanguard or Amundi, offer fixed income investment funds to their clients. In many cases, these are available as exchange-traded funds. That allows us, as individual investors, to choose what we want to invest in.

Due to the thousands of fixed income funds available, it is possible to design very sophisticated strategies. Whether it is Swiss debt, emerging market debt, US mortgages, junk bonds, or long-term US Treasuries, we will find what we are looking for.

Hedge Funds

Finally, we must also mention hedge funds. Hedge funds are institutional investors that can invest in a wide range of assets. In this sense, they have much more flexibility than most traditional investment funds, which often have many restrictions in terms of what they can trade.

Hedge funds use the fixed income market to speculate and bet on the direction of interest rates, the level of inflation in the economy, and the state of different corporate bond sectors.

If you want to learn more about the fixed income market and how it works, check out this section:
Bonds

I also encourage you to subscribe to my newsletter:
Clear Finances