Asset Classes - Fixed Income

A primer on bond investing

Now that we’ve looked at Equities, we’ll pick up the next most popular asset class - fixed income.

Fixed income is a broad term that covers a variety of debt securities also known as bonds. In terms of understanding them, there are a few terms to note:

  • Face Value or Notional: This is the principal amount
  • Coupon Rate: This is the interest rate paid out to the holders. The rate is usually stated annually, but can be stated per coupon term
  • Coupon: This is the amount paid out as interest
  • Coupon Schedule: This is the schedule of payments - it could be monthly, quarterly, semi-annually, annually and so on
  • Maturity: This is when the security expires(terminates) and the principal is paid back to the holders.
  • Issuer: The entity issuing the bond
  • Guarantor: THe entity that guarantees payments if the issuer defaults on them. Not all bonds would have a guarantor.

There are many types of bonds. Some of the key ones are:

  • Government Bonds: These are issued by governments when they wish to raise some debt. Examples are T-bills in the US. They are considered the highest rated security for a domestic investor.
  • Municipal Bonds: Like the above, but issued by local governmental bodies or institutions.
  • Corporate Bonds: These come in various forms and flavors, and the key point to note is their debt rating. In general, the higher the rating, the safer the instrument is, and the lower its offered coupon is.
  • Asset Backed Securities: These would be mortgages or car loans and the like repackaged into bonds. The returns on these bonds (and the risk) are determined by whether the underlying loans pay back on time (or at all)
  • Certificates of Deposit: This is offered by banks, credit unions, cooperatives and so on. Its simplicity should not blind you to the fact that it’s safety depends on the solvency and stability of the institution backing it.
  • Zero coupon bonds: This is a variation of a standard bond, where you buy it at a discount and it pays no coupons. It’s nominal coupon rate can be calculated by its discount. i.e. - if a bond matures in a year, and is offered at a 10% discount to its face value, then the nominal coupon rate on it is 10%.
  • Floating rate bonds: Here, the coupon is not fixed, but is stated as being relative to some other rate - say your government’s borrowing rate + 2%. As the rate it depends on(reference rate) changes, so does your coupon rate. These bonds introduce a second schedule to be aware of - a fixing or reset schedule, which is when the new rate is computed and ‘fixed’ for the subsequent period.

Outside of these, you might be holding fixed income indirectly through your mutual funds, pension funds, retiral accounts and so on. It is a good idea to understand the underlying holdings and structure of these accounts so that you have a clear idea of their expected performance and risks.

Investing in fixed income alongside other asset classes is a good idea as it offers you a greater degree of safety as a cushion from exploding markets and the like. It also offers decent diversification as the correlation with equities is low except in cases where a country heads into a recession with both falling markets and rising inflation(which causes rising interest rates). In those cases too, you can expect your bonds to fall less than your equities. The cost of this safety is relatively lower growth and yields.

A last point to understand is the behavior of bonds to interest rates. When interest rates fall, your bonds will rise in price as they become more attractive compared to buying a fresh one at prevailing coupon rates. When rates rise, your bonds will fall for the same reason.

And that’s it for a whistle-stop tour of fixed income.