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".
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.
Fixed income securities are issued by a wide array of organizations. Probably the best known and most liquid of them all are the government instruments, which are often referred to as sovereign debt because they
are issued by national governments. They come in a wide array of varieties and maturities from country to country, though the most commonly traded securities tend to be the notes and bonds. They have names like Gilts (UK), Bunds (Germany), and JGBs (Japan). Individuals can trade in government debt via the cash market through direct purchase, or they can go through the futures market.
Corporate debt is also quite well common. A great many companies issue debt as an alternative to issuing more stock. Many of these issues, generally notes and bonds, are
listed and traded on stock exchanges. As such, they are readily tradable by anyone with a
States, counties, cities and towns also issue debt, which is commonly referred to as municipal or
"muni" debt. These issues are often less well known and less actively traded than government or corporate securities. Unlike the other two, however, they often come with incentives for the debt holder such as the interest being federally tax-deductible. As such, they will generally trade at lower yields.
Government agencies and quasi-government agencies also issues fixed income instruments. Among the best known in the U.S. are the Federal National Mortgage Association (FNMA – Fannie Mae) and the General National Mortgage Association (GNMA – Ginnie Mae). Like government debt, these instruments are accessible to the individual through either the cash or futures market.
The last major group of issuers is the supra-national organizations such as the World Bank. These issues are not commonly a part of the portfolio of the individual trader, but can be transacted in the cash market.
Fixed Income securities all have ratings assigned to them by one or more credit agencies. These ratings are an indication of the creditworthiness of the issuer. They are essentially an indication of how likely the instrument is to be paid off by the terms of its issuance. The higher the rating the better. For example, the sovereign debt of most major industrial countries is of the highest rating. So too are those of many large corporations. An issuer need not have a top level rating for it’s securities to be considered a good risk, though the yields will generally increase with lower debt ratings.
Non-investment grade debt, or junk as it is often called, is the collection of securities which carry low ratings. Issuers with ratings in this category often have high amounts of debt outstanding, may possibly have defaulted, or otherwise are considered to be in financial stress, suggesting that the debt holder is at risk of not being paid off as per the terms.
Influences on Fixed Income Prices
Since the fixed income market is driven by interest rates (prices are inversely related to yields), those things which impact on rates directly influence prices. The biggest driver of these rates, from a macro perspective, is monetary policy
– the decisions central banks make in regards to the level of domestic interest rates. Since the central banks directly control interest rates (at least short-term rates), they have a heavy influence over their level and direction. Other, less direct, influencers include:
- Government fiscal policy
- General economic growth
- Currency exchange rates and trade
Obviously, when considering the likes of corporate debt, considerations related to that particular issuer come in to play. This includes things like earnings, total debt outstanding, interest cover ratios, and others. All of this, though, is also account for in the credit rating.
The yield curve is the graphic portrayal of yields over the array of maturities, from shortest to longest. An example is shown on the following chart.
Notice that the plot above depicts two lines. The blue line is the more standard, upwardly sloping yield curve in which the longer-maturities feature higher yields. The spread between the long maturity issues over the short maturity ones is positive. The pink line, shows an inverted, or negatively sloped curve. A negatively sloped curve is often considered an indication of a pending downturn in the economy as the higher return on short term money will tend to prevent longer-term investment.
It should be noted that while it is most often the case that when one discusses yield curves that it is the government rate curve to which is being referred, it need not always be the case. There are yield curves for corporate debt, for example.
- Mortgage-Backed Security (MBS): Instruments which are based on commercial and residential property mortgage loans. These loans are packaged together and securitized by the likes of Fannie Mae. The primary consideration for an MBS is that since mortgages can be prepaid, the actual maturity of the security is unknown, though it can be estimated.
- Convertible: Some bonds and notes (mostly corporate) can be exchange for another security (generally stock). For example, a company could issue a bond which allows the holder to convert the bond in to 10 shares of company stock. The terms of these conversions are pre-set in terms of price of the security into which the issue can be converted, and oftentimes also the timeframe in which the conversion is allowed. The price of convertible securities are heavily influenced by the price of the security
in to which they are convertible.
- Inflation Protected Securities: This is a group of fixed income securities which are tied in to inflation, as measured by the
Consumer Price Index (CPI) or some other similar measure. The interest and/or principal payments of such instruments vary based on a formula. The idea is the nullify the influence of inflation on the holder so that the real rate of return (nominal rate minus inflation) will remain fairly steady.
This article is but a brief introduction to fixed income. If you wish to go further, consider the following as worthy resources.
The Handbook of Fixed Income Securities by Frank Fabozzi
This book is considered the bible among market participants and academics alike. It is very comprehensive.
The Bond Market by Christina Ray
While not nearly as thorough as the Fabozzi book above, it is a very practical guide to the markets in application.