What Is Fixed Income explained by professional Forex trading experts the “ForexSQ” FX trading team.
What Is Fixed Income?
Definition: Fixed income is an investment that returns a payment to you on a regular schedule. This most commonly includes pensions, bonds and loans. It also includes Certificates of Deposit (CDs), savings accounts, money market funds, and annuities. You can also invest in fixed income securities with bond mutual funds, Exchange Traded Funds (ETFs), and fixed income derivatives.
Demand for fixed income investments skyrocketed after the 2008 recession.
That’s because the Federal Reserve’s expansionary monetary policy kept interest rates at a record low for seven long years. Risk averse investors shifted a greater proportion of their portfolios to fixed income products to maintain payments at the same level. (Source: Corrie Driebusch, “Some Investors Can’t Wait for the Fed to Raise Rates,” The Wall Street Journal, April 20, 2015.)
Types of Fixed Income
Short-term: The interest rates on these accounts are based on the Fed funds rate, or equivalent Treasury bill rates of four years or less. Since the Fed funds rate was lowered to zero in 2008, these products also earned super-low interest rates. To gain a higher yield, individual investors shifted from short-term to longer-term investments. Businesses use short-term loans to cover the cash flow needed to pay for day-to-day operations.
Savings Accounts: The bank pays you a fixed rate of interest, based on the Fed funds rate.
You can add or withdraw whenever you like.
Money Market Accounts: The bank pays you a slightly higher fixed rate of interest. In return, you must keep a minimum amount deposited. You are also limited on the amount of transactions you can make in a year.
Certificates of Deposit (CDs): You must keep your money invested for an agreed-upon period of time to get the promised rate of return.
Thanks to low interest rates, there’s only $1.7 trillion invested at the end of 2014. That’s half of the $2.5 trillion invested at the end of 2006, according to the FDIC.
Money Market Funds: These are mutual funds that invest in a variety of short-term investments. You get paid a fixed rate based on short-term U.S. Treasury securities, federal agency notes, Eurodollar deposits, repurchase agreements, certificates of deposit, corporate commercial paper, or obligations of states, cities, or other types of municipal agencies. For more, see Fidelity’s Money Market Funds.
Short-term Bond Funds: These mutual funds invest in one- to four-year corporate and other safe bonds.
Individual Bonds: This is how organizations obtain very large loans. Unlike loans, bonds can bought or sold like any security. Generally, when stock prices go up, bond prices go down, because bonds are perceived as lower return and lower risk than stocks. They are generally bought when investors are afraid of taking on risk.
There is nearly $21 trillion invested in bonds globally, as of December 2014. Of that, $5.5 trillion is in floating-rate bonds, and $15.1 trillion in fixed rate. (Source: “Table 13.b. International Bonds and Notes,” Bank for International Settlements.)
There are many different types of bonds. The safest are issued by the government, such as Treasury bills, notes and bonds ($12.5 trillion outstanding), municipal bonds ($3.7 trillion outstanding), savings bonds, . Since they’re the safest, they offer the lowest fixed income.
That’s why many investors have turned to corporate bonds (currently $7.8 trillion outstanding) that offer a higher rate. They are issued by companies that need a lot of extra cash but don’t want to issue stocks. (Source: “Outstanding U.S. Bond Market Debt,” Securities Industry and Financial Markets Association (SIFMA), as of December 2014)
There are two hybrids of corporate bonds and stocks. Preferred stocks pay a regular dividend, even though they are a type of stock. Convertible bonds are bonds that can be converted to stocks.
Although technically not a fixed income, stocks that pay regular dividends are often substituted for fixed income bonds and are often treated as such.
Eurobonds is the common name for Eurodollar bonds. They are corporate bonds issued in euros instead of their own country’s currency or U.S. dollars.
Bond Mutual Funds: These are mutual funds that own a large number of bonds. That allows the individual investor to gain the benefits of owning bonds without the hassle of buying and selling them. Mutual funds grant greater diversification than most investors could gain on their own. For more, see What’s the Difference Between Bonds and Bond Funds?
Exchange Traded Funds (ETFs): Bond ETFs are growing in popularity since they have lower costs. They merely track the performance of a bond index, instead of active management like a mutual fund.
Fixed Income Derivatives: These are financial products that derive their value from underlying bonds. They are used by sophisticated investors, companies, and financial companies to hedge against losses. These include:
- Options gives a buyer the right, but not the obligation, to trade a bond at a certain price on an agreed-upon future date. The right to buy a bond is called a call option and the right to sell it is the put option. They are traded on a regulated exchange.
- Futures contracts are like options, except they obligate participants to execute the trade. They are traded on an exchange.
- Forward contracts are like futures contracts, except they are not traded on an exchange. Instead they are traded Over the Counter (OTC), either between the two parties directly or through a bank. They are often very customized to the particular needs of the two parties. For example, Mortgage To-Be-Announced (TBAs) are forward contracts for mortgage-backed securities sold at a future date.
- Mortgage-backed securities are based on bundles of home loans. Like a bond, they offer a rate of return based on the value of the underlying assets.
- Collateralized debt obligations are based on auto loans and credit card debt, but also included bundles of corporate bonds.
- Asset-backed commercial paper are one-year corporate bond packages based on the value of underlying commercial assets, such as real estate, corporate fleets or other business property.
- Interest rate swaps are contracts that allow bond holders to swap their future interest rate payments. These are typically between a holder of a fixed-interest bond and one holding a flexible-interest bond. They are traded Over The Counter. Swaptions are options on an underlying interest rate swap.They are a derivative based on a derivative, and are used to speculate about interest rate movements. For more, see Bond Options, Swaps and Swaptions.
- Total return swaps are like interest rate swaps, except the payments are based on bonds, a bond index, an equity index, or a bundle of loans. (Source: “Introduction to Fixed Income Derivatives,” Enis Knupp and Associates. “Overview of Derivatives,” CBOE Group. “Understanding Treasury Futures,” CME Group.)
Third-Party Fixed Income Payment Streams
There are three other ways of achieving a fixed income stream of payments that aren’t dependent on the value of an investment. Instead, the payment is guaranteed by a third party.
Social Security: Fixed payments available after a certain age. It’s guaranteed by the Federal Government, and is calculated based on payroll taxes you’ve paid. It’s managed by the Social Security Trust Fund.
Pensions: Fixed payments guaranteed by your employer, based on number of years you worked and your salary. Companies, unions, and governments use pension funds to make sure there’s enough to make the payments. As more workers retire, fewer companies are offering this benefit.
Fixed-Rate Annuities: An insurance product that guarantees you a fixed payment over an agreed-upon period of time. These are increasing since fewer workers receive pensions.
How Fixed Income Affects the U.S. Economy
Fixed income provides most of the liquidity that keeps the U.S. economy humming. Businesses go to the bond market to raise funds to grow. They use money market instruments to get the cash needed for day-to-day operations. Here’s what happened when there was a run on those money markets.
In addition, Treasury bills, notes and bonds help set interest rates. How? When demand for Treasury bonds fall, yields rise. Interest rates on loans, mortgages, and all other fixed-income products track those of similar Treasury products. For more, see How Are Interest Rates Determined?
Low interest rates might trigger inflation. That’s because there’s too much liquidity chasing too few goods. If inflation doesn’t show up in consumer spending, it might create asset bubbles in investments.
You can also use Treasury yields to predict the future. For example, an inverted yield curve usually heralds a recession.
When that happens, it has the same effect on mortgage interest rates. This affects demand for real estate, which supports 6% of the economy. For more, see How Do Bonds Affect Mortgage Interest Rates?
The demand for Treasury notes is one also of the three factors that affects the value of the dollar. That’s because both are seen as safe haven investments, and tend to rise and fall together. However, sometimes the higher interest rates that occur when Treasury prices fall (remember, they have an inverse relationship) will drive up demand for the U.S. dollar.
What Is Fixed Income Conclusion
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