Fixed-income

Fixed-income (also known as 'debt securities') refers to a type of investment where an investor lends money to an entity (like a corporation or government) which borrows the funds for a defined period of time at a variable or, more commonly, fixed interest rate. Think of yourself as the bank for a moment. You lend money, and in return, the borrower promises to pay you back your original loan amount on a specific future date, plus regular interest payments along the way. This predictable stream of payments is where the name “fixed-income” comes from. It's the steady, reliable cousin to the more volatile world of Equity investing. The most common examples you'll hear about are Bonds, but the category also includes other instruments like Treasury Bills and Certificates of Deposit (CDs). For investors, fixed-income is often the bedrock of a portfolio, prized for its potential to preserve capital and generate consistent cash flow.

The mechanics are refreshingly straightforward. When you buy a fixed-income security, you are essentially purchasing a promise. The issuer promises to make periodic interest payments, known as coupon payments, over a set term. At the end of that term, on the maturity date, the issuer repays the original amount of the loan, which is called the principal or face value. Let's make it real. Imagine you buy a 10-year corporate bond from “SteadyEddie Inc.” with a face value of $1,000 and a 5% coupon.

• You pay $1,000 today to buy the bond.
• SteadyEddie Inc. pays you $50 every year for 10 years (that's your 5% coupon: $1,000 x 0.05).
• After the 10th year, the bond “matures,” and the company gives you your original $1,000 back.

Over the decade, you collected $500 in interest and got your initial investment back. Simple, predictable, and fixed.

A wide range of entities issue debt to raise money, but they generally fall into two major camps.

Governments are the biggest players in the bond market. They issue debt to fund everything from infrastructure projects to public services. Government debt from stable, developed countries is generally considered the safest type of investment.

• United States: Issues debt like Treasury Bonds (long-term), Treasury Notes (medium-term), and Treasury Bills (short-term). Their perceived safety is so high that their yield often serves as the global risk-free rate.
• Europe: You'll find a variety of government bonds, such as Gilts in the United Kingdom or Bunds in Germany, which are similarly seen as very safe investments.

Companies issue corporate bonds to raise money for expansion, research, acquisitions, or simply to manage their day-to-day operations. Unlike governments that can raise taxes to pay their debts, companies rely on their business success. This introduces a new element: credit risk. This is the risk that the company might run into financial trouble and fail to make its payments, known as a default. To help investors gauge this risk, independent agencies like Moody's and Standard & Poor's provide credit ratings.

• Safe & Sound: Bonds with high credit ratings are called investment-grade bonds. They are issued by stable, profitable companies and offer lower interest rates because the risk of default is low.
• High Risk, High Reward: Bonds with poor credit ratings are known as high-yield bonds (or, more colourfully, 'junk bonds'). To compensate investors for taking on the higher risk of default, these bonds offer much higher interest payments.

While stocks might get all the glory, a true value investor appreciates the quiet power of fixed-income. It’s not about getting rich quick; it’s about building a resilient financial foundation.

• Capital Preservation: The primary goal of holding high-quality bonds is often to protect your principal. While the price of a bond can fluctuate, if you hold a bond from a reliable issuer to maturity, you can be highly confident you'll get your money back.
• Diversification: Fixed-income often zigs when the stock market zags. During a stock market downturn, high-quality government bonds can act as a stabilizing force in a portfolio. This is a core principle of asset allocation.
• Income Generation: For those in or near retirement, the steady, predictable coupon payments from a bond portfolio can provide a reliable income stream to cover living expenses.

This is the most important concept to grasp: bond prices have an inverse relationship with interest rates.

• When interest rates RISE: Newly issued bonds will offer higher coupon payments. This makes your existing, lower-coupon bond less attractive, so its market price will fall.
• When interest rates FALL: Your existing bond, with its relatively high coupon, suddenly looks very appealing. This increased demand will cause its market price to rise.

This sensitivity to interest rate changes is known as interest rate risk.

A value-oriented bond investor does more than just buy and hold. They hunt for bargains. This might mean buying a bond trading below its par value because the market is panicking about temporary bad news. If your analysis shows the issuing company is fundamentally sound and will not default, you can lock in a higher effective yield and potential price appreciation. Even the great Benjamin Graham advocated that the “defensive investor” should always have a significant portion of their portfolio in high-quality bonds.

Remember, “fixed” does not mean “risk-free.” While generally safer than stocks, fixed-income investments carry their own unique set of risks.

• Interest Rate Risk: As we saw, if rates go up, the market value of your bond goes down.
• Credit Risk: The risk that the issuer defaults on their payments. This is the primary risk in corporate and high-yield bonds.
• Inflation Risk: This is the silent wealth-killer. The risk that the rate of inflation outpaces the fixed interest rate you are receiving, meaning your investment loses purchasing power over time. A 2% bond return doesn't help you much if inflation is running at 4%!