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What is fixed income?

What is fixed income?

Many sharemarket investors are startled when they are told that the global fixed income market is more than twice the size of all those sharemarkets put together.

It doesn’t resonate quite so much with retail investors since the big part of the fixed interest market is in Government Bonds, an asset class of more interest to sovereign wealth funds, insurers and big institutional investors.

A bond is a promise, an obligation to pay the investor back at some fixed point in the future.

“Fixed interest” sounds dull until you realise that if for instance a government is being forced to borrow more money than the investing public wants to put up, it has no option but to offer a more generous rate of interest. It’s only fixed at the point of issue.

That’s been a consequence of President Trump’s massive tax cuts in the US: the US government has had to raise the interest rates on the new bonds it is offering, to help fill the yawning deficit caused by the looming reduction in tax revenues.

And there’s a perfect balance in the bond market, an iron law: as interest rates move up, the prices of previously issued bonds correspondingly go down.

So why, given that is what is happening now, should retail investors look to invest in the fixed interest market?

Aside from being uncorrelated to the sharemarket, it’s a much safer place to invest. You will almost certainly be paid back and will be paid quarterly distributions as well. And more relevantly, there is money to be made in what’s called the commercial paper market.

That relates to bonds issued by companies in preference to borrowing from the banks. Because the issuers are rated around B rather than the A of government bonds, the coupons or yields being offered by corporates have to be higher than government bonds, to compensate for the extra risk.

A bond is a promise, an obligation to pay the investor back at some fixed point in the future, and even “distressed” bonds have a value to risk tolerant investors who might buy the bonds at 20 cents in the dollar, in the hope of being paid out a bigger amount when the company is liquidated or it recovers. There are few tragedies in the bond market.

Despite the fixed interest market having historically been the province of big institutions playing in half million dollar positions, there are now managed funds aimed at retail investors which specifically bundle bite-sized bond holdings in a  way that helps to diversify risk plus provide the retail investor with a relatively risk free quarterly distribution flow.

If the investor can get in at a time when a company is under some stress and the yield has risen, that means the price has dropped inversely and there could be some handy capital gains in the future for the investor.

 

This is an article in our investment starter series. You can read more here.

This is the view of the author, Andrew Main. This article is general in nature and does not take into account your personal circumstances.