What is fixed income investing?
Companies have two ways of raising money for their balance sheet. They can sell a stake in their ownership via shares, which is referred to as “equity”, or they can borrow money by raising debt. This debt is issued as a “bond” and is generally known as “fixed income”.
First, the lingo: The name “fixed income” is derived from the interest payments on this debt being fixed. A company will offer its debt to the market and that debt will pay interest at a fixed annual rate until the bond matures and the debt is paid back. The income is therefore fixed.
Equity gives you a stake in the company and a share of its profits. Those profits are often very variable, so the share price of a company can move around a lot.
The payoff from a bond is much more certain. If a company offers the market a bond with a 5% coupon, this bond will pay 5% on its principal amount. If you were to buy and hold this bond to maturity, its payoff is very straightforward. You lend the company, say, $100,000 and the company will pay you $5,000 p.a. until the bond matures when you receive your final interest payment along with the original principal amount.
Bonds also rank before equity in the capital structure of the company.
This means if the company falls into bankruptcy and its assets are sold off, bond holders receive whatever money can be retrieved before equity holders. If bond holders can’t be repaid in full, then equity holders receive nothing. Thus, fixed income is considered a safe asset class – for principal at risk, volatility of the asset and certainty of the income.
There is a huge secondary market for bonds, so a bond holder doesn’t need to wait until maturity to get their principal back. However, things become a little more complicated than in the above hold-to-maturity example. Two things affect a bond’s price: credit quality and interest rates. Here’s how:
In the above example, let’s say the bond has one year until it matures. A buyer of the bond who paid $100,000 would get their money back at year end plus the interest of $5,000.
However, what if the issuer’s credit quality has deteriorated?
Perhaps business is tough and the market is wondering if the company will even be around next year. In that case, a buyer would discount the bond for the increased risk and offer less than the $100,000 face value. Of course, this also works in reverse. If business is booming and the company is profitable, its credit quality may have increased so a buyer may pay more than $100,000 for the bond because other bonds paying the same interest rate may look riskier.
Now let’s say that interest rates have been slashed. Instead of issuing bonds at 5%, similar companies can now borrow at 2%. That juicy $5,000 payment heading for the owner at the end of the year means that buyers will bid more for the bond because they can’t get a return like that elsewhere. How much? Bidding would stop at $102,900, which would give a yield of exactly 2% on the remaining life of the bond.
Again, the reverse is also true. If rates went to 10% for these types of bonds, why pay $100,000 for one yielding 5% when you can get one yielding 10% instead? Thus, buyers would offer just $94,500 for the bond, providing a yield of exactly 10%.
Managing all this is complicated work, and in today’s interest rate environment bond portfolios need to be carefully put together. eInvest has three fixed income, actively managed ETFs that are managed by our partners Daintree Capital. They provide different rates of return based on different levels of risk:
ECAS – Lowest risk fund targeting 0.5% above RBA cash rate
ECOR – High capital stability targeting 2% above RBA cash rate
EMAX – Income maximiser targeting 4% above RBA cash rate
Bond ETFs aren’t cash, but with banks paying around 0.15% for cash these days, they are a conservative option that provide extra income.
Disclaimer: Please note that these are the views of the writer, Tamas Calderwood, Distribution Specialist at eInvest and is not financial advice. To find out how to invest in our active ETFs, visit here. The product disclosure statement and more can be found at www.einvest.com.au. If you’d like to keep learning further, please feel free to follow any of our socials listed below.