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This article is a basic introduction to the fixed income market.  It covers the primary facets and features of fixed income as they relate to trading from the individual, as opposed to institutional, perspective.

The term "fixed income" is used to describe a collection of securities which have predefined pay-out terms.  An example would be a certificate of deposit (CD) in which one deposits a set amount of money and in return receives a given amount of money, which includes both the original deposit plus interest income, at some future date, known as the maturity.  Fixed income securities, unlike stocks, are based on loans.  While one might think of "buying" a CD, what he/she is in fact doing is loaning the bank money, for which they are paying interest.  That interest, which is pre-determined in some fashion at the outset, is the "fixed income".

Money Markets

Fixed income securities come in a wide array of maturities.  Those with initial maturities of one year or less trade in what is often referred to as the money market.  This term comes from the fact that these short-term instruments tend to be very liquid and often traded between banks.  Money market instruments included such things as:

• Bankers' Acceptance: A draft or bill of exchange accepted by a bank to guarantee payment of a bill.
• Certificate of Deposit: A time deposit with a specific maturity date shown on a certificate; large-denomination certificates of deposits can be sold before maturity.
• Commercial Paper: An unsecured promissory note with a fixed maturity of one to 270 days; usually it is sold at a discount from face value.
• Eurocurrency Deposit: Currency deposits in a domestic bank branch or a foreign bank located outside the country of the currency in question.  For example, Eurodollars are deposits of US Dollars outside the United States.
• Federal Agency Short-Term Securities (in the US): Short-term securities issued by federally sponsored agencies such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association.
• Federal Funds (in the US): Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve.  These are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.
• Municipal Notes: Short-term notes issued by municipalities (cities, towns, counties, etc.) in anticipation of tax receipts or other revenues.
• Repurchase Agreements: Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.
• Treasury Bills: Short-term debt obligations of a national Treasury issued to mature in 3 to 12 months.

Most of the securities above are out of the realm of the individual trader, but a handful can be traded, generally via the futures markets.  Money market instruments normally trade at a discount which means the buyer (lender) pays some amount below the final pay-off value.  For example, if a Treasury Bill is going to pay 100 at maturity, the buyer might pay 95.  The difference would be the interest earned.

Notes and Bonds

The intermediate term fixed income market is made up of securities which are generally (but not exclusively) referred to as notes.  They are instruments which have initial maturities of two to ten years.  Bonds, on the other hand, are the longer-term instruments with initial maturities of more than ten years at the time of issuance.

The standard structure of notes and bonds are the same.  They each feature a par or principle value which is paid at maturity, as well as intermediate interest payments, referred to as coupon payments, which are paid out on a predefined periodic basis (monthly, semi-annually, etc.).  The coupons represent the nominal interest on the bond or note.  For example, if a bond has a 100 par value, and a coupon of 10 per year, that means a 10% interest rate.

Notes and bonds, however, will not always trade at par value.  Depending on the overall interest rate market, they can be priced at a discount (below par) or at a premium (above par).  The result is that the effective interest rate may not be the same as the nominal rate.  For example, if the bond  above were trading at 90, the effective interest rate would be 11.11%.  Note, though, that the bond price of 90 represents a 10 point discount off the 100 par value.  Those 10 points become extra profit to the bondholder when he/she is paid par at maturity.  That then becomes part of the yield to maturity equation.  If the bond in the example has a 20-year maturity, its yield to maturity is about 11.28%.  Were the bond trading at a premium (above 100), then the yield to maturity would be lower than both the effective and nominal interest rate.

Notes and bonds are both actively traded on a number of exchanges.  Individual traders can transact in them via either the cash or futures market.

Callable vs. Non-Callable

Some fixed income instruments are callable.  That means the issuer can essentially buy them back from the holders prior to maturity.  Normally there are specific terms related to this such as a date after which calling is allowed, or not allowed.  When an issue is called, the holder receives the par or principal value, and sometimes a premium as well, depending on the call conditions.