INTRODUCTION TO FIXED INCOME

INTRODUCTION

A type of investing or budgeting style for which real return rates or periodic income is received at regular intervals at reasonably predictable levels. Fixed-income budgeters and investors are often one and the same - typically retired individuals who rely on their investments to provide a regular, stable income stream. This demographic tends to invest heavily in fixed-income investments because of the reliable returns they offer.


Individuals who live on set amounts of periodically paid income face the risk that inflation will erode their spending power. Fixed-income investors receive set, regular payments that face the same inflation risk.

TYPES OF FIXED INCOME

The most common type of fixed-income security is the bond, a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. From now onward, we will focus solely on bonds.


There are three main categories of bonds:


1. Corporate Bonds: A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years, and long term is over 12 years. 

Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed-income investments because of the risk the investor must take on. The company's credit quality is very important: the higher the quality, the lower the interest rate the investor receives. 


Other variations on corporate bonds include convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity. 

  • Convertible Bonds: Corporate bonds that allow bond holders to convert their creditor position to that of an equity holder at an agreed upon price.

  • Callable Bonds: A bond that can be redeemed by the issuer prior to its maturity. Usually a premium is paid to the bond owner when the bond is called. Check the video on the left for more information about callable bonds.

CALLABLE BOND

A bond that can be redeemed by the issuer prior to its maturity. Usually a premium is paid to the bond owner when the bond is called.

TYPES OF FIXED INCOME

2. Municipal Bonds: A debt security issued by a state, municipality or county to finance its capital expenditures. Municipal bonds are exempt from federal taxes and from most state and local taxes, especially if you live in the state in which the bond is issued.


Municipal bonds, known as "munis", are less risky than corporate bonds. Cities don't go bankrupt that often, but it can happen. The major advantage to munis is that the returns are free from federal tax. Furthermore, local governments will sometimes make their debt non-taxable for residents, thus making some municipal bonds completely tax free. Because of these tax savings, the yield on a muni is usually lower than that of a taxable bond. Depending on your personal situation, a muni can be a great investment on an after-tax basis. 


3. Government Bonds: In general, government fixed-income securities are classified according to the length of time before maturity. These are the three main categories:


  • Bills: Debt securities maturing in less than one year. 

  • Notes: Debt securities maturing in one to 10 years. 

  • Bonds: Debt securities maturing in more than 10 years. 

For example, the Treasury Bond, or commonly called the T-Bond, T-Notes, and T-Bills (though T-Bills are not bonds because of their short maturity) are issued by the U.S. government.


  • T-Bonds: A marketable, fixed-interest U.S. government debt security with a maturity of more than 10 years. Treasury bonds make interest payments semi-annually and the income that holders receive is only taxed at the federal level

  • T-Notes: A marketable U.S. government debt security with a fixed interest rate and a maturity between one and 10 years. Treasury notes can be bought either directly from the U.S. government or through a bank. 

    • When buying Treasury notes from the government, you can either put in a competitive or noncompetitive bid. With a competitive bid, you specify the yield you want; however, this does not mean that your bid will be approved. With a noncompetitive bid, you accept whatever yield is determined at auction.

  • T-Bills: A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations of $1,000 up to a maximum purchase of $5 million and commonly have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks).

Zero Coupon Bonds: This is a type of bond that makes no coupon payments but instead is issued at a considerable discount to par value. For example, let's say a zero-coupon bond with a $1,000 par value and 10 years to maturity is trading at $600; you'd be paying $600 today for a bond that will be worth $1,000 in 10 years. 

CHARACTERISTICS OF BONDS

Most bonds share some common basic characteristics including:

  • Face value is the money amount the bond will be worth at its maturity, and is also the reference amount the bond issuer uses when calculating interest payments.

  • Coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a percentage.

  • Coupon dates are the dates on which the bond issuer will make interest payments. Typical intervals are annual or semi-annual coupon paymets.

  • Maturity date is the date on which the bond will mature and the bond issuer will pay the bond holder the face value of the bond.

  • Issue price is the price at which the bond issuer originally sells the bonds.


Two features of a bond – credit quality and duration – are the principal determinants of a bond's interest rate. If the issuer has a poor credit rating, the risk of default is greater and these bonds will tend to trade a discount. Credit ratings are calculated and issued by credit rating agencies. Bond maturities can range from a day or less to more than 30 years. The longer the bond maturity, or duration, the greater the chances of adverse effects. Longer-dated bonds also tend to have lower liquidity. Because of these attributes, bonds with a longer time to maturity typically command a higher interest rate.

BONDS' YIELD AND PRICE

Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.

Let's demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).

Of course, these matters are always more complicated in real life. When bond investors refer to yield, they are usually referring to yield to maturity (YTM). YTM is a more advanced yield calculation that shows the total return you will receive if you hold the bond to maturity. It equals all the interest payments you will receive plus any gain (if you purchased at a discount) or loss (if you purchased at a premium). The current yield tells investors what they will earn from buying a bond and holding it for one year.

 

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