—  WHAT IS FIXED INCOME?  —

When we speak about the fixed income asset class, what we're really talking about are debt securities. By purchasing debt securities, we are becoming lenders of capital to an issuing entity, such as a corporation or a government. In exchange for lending out money, we often receive regular interest payments (called coupons) throughout the term and then receive a principal payment back on the maturity date (usually in multiples of $1,000).

The above scenario describes a bond, but fixed income securities can come in many different options including debentures, preferred shares, and mortgage securities. They are structured in a way which meets the need of the issuer, and it is up to us to determine whether they are appropriate investments for our portfolio.

Most of us will invest primarily in bonds, so the bulk of this section will be dedicated to these securities. Broadly speaking, bonds are either government issued or corporate issued. Government issued bonds are considered risk-free and the most secure type of bond. This is because governments have the ability to create new money if they fall short, allowing them to virtually guarantee payments. Since payments are guaranteed, the returns aren’t usually very high. In contrast, corporate-issued bonds carry a higher degree of risk and therefore, the returns are always going to be higher. Generally speaking, the more risk there is, the higher the returns will be. However, the risk of default (i.e. not making a coupon payment on time or worse, not paying back the principal amount) increases. Credit rating agencies such as S&P and Moody’s specialize in analyzing the creditworthiness of debt issuers, and the market uses this information to value the bonds and determine an appropriate level of return.

— HOW ARE BONDS PRICED? —

Bond pricing can be complex, but there is one relationship you should always remember: as interest rates and yields (i.e. returns) rise, bond prices fall. This inverse relationship is key to understanding how bonds work. The following example isn’t information you need to know as an investor; it is simply meant to illustrate the relationship between bond yields and prices.

Consider a one year bond that will pay a you a 2% coupon once per year and then return a $1,000 principal payment at the end of the year. The bond’s yield (i.e. return) is 5%. The information given tells us that we will receive a $20 payment (2% of $1,000) along with a $1,000 principal payment at the end of the year for a total of $1,020. But since we aren’t getting that money today, we have to divide the cash flow amounts by the discount rate (the yield) each year. So our first and only cash flow payment is calculated as $1,020 / 1.05 = $971.

Now let’s say that the bond’s yield was only 4% instead of 5%. Our calculation would then be $1,020 / 1.04 = $981. A higher price resulted from a drop in yield.

— WHAT ARE THE DIFFERENT CREDIT RATINGS?—

As mentioned earlier, corporate bonds are riskier than government bonds simply by virtue of not being backed by the government. If a corporation cannot make its debt payment, there’s no guarantee the government will rush in and bail them out, so there is at least some level of risk you take when investing in any corporate bond. Credit rating agencies exist to assist investors in determining the likelihood that the issuer will default on their payments. Obviously this information is of huge importance to an investor, as not getting paid on time (or at all) could have a significant effect on your portfolio’s returns.

The three main credit rating agencies are Moody’s, S&P and Fitch. They all have subtle differences in their ratings, so the table below (provided by the Association of Corporate Treasurers) is a guide to help you understand what all the ratings you may read about in articles actually means.

— WHy invest in bonds?—

There are four often-cited reasons for investing in bonds.

1. Regular Income: bonds usually provide semi-annual payments, and can be easily tailored to an investors’ needs. There are high risk and low risk bonds, high income and low income ones, short-term and long-term ones. And that’s just the basic kinds of bonds. Especially for investors nearing retirement age or looking to supplement their pension and governmental benefits, bonds provide for an easy way to do so.

2. Capital Gain Possibilities: depending on what you purchased a bond for, you may end up realizing a capital gain on it at the time of maturity in addition to the income you received throughout its term. These days, however, bonds are trading at premiums, which means their value steadily declines as they approach maturity and you will ultimately realize a capital loss. Don’t underestimate that capital loss, though. You can use it to offset capital gains in your equity portfolio to ultimately lower your tax bill.

3. Risk Reduction: bond and stock returns often move in opposite directions, but a healthy allocation to bonds can really help you out during economic downturns. As discussed in a recent newsletter, bonds have historically provided investors with positive returns in practically every year with much less risk than stocks. Investors can use them to manage the amount of risk they are willing and able to take on.

4. Safety: when you loan an entity money, it represents a legal contract. The bond issuer must pay you back on the maturity and coupon dates), or it is said to be in default. This is in contrast to dividend payments from equity securities, where we may come to expect the payments but companies are under no obligation to actually follow through. Now, issuers may default on their loans for a myriad of reasons, but that is why tools such as credit ratings are used to judge the likelihood of this happening.