Fixed income 101 – part 1

Fixed income 101

Written by James Weir

James specialises in the theory and best practice of portfolio construction and management. His success within national and international investment banks led him to become a Co-Founder of Steward Wealth and he is a regular columnist for the Australian Financial Review.
January 27, 2015

The global fixed income market is about two to three times the size of the global equities market, yet the average Self-Managed Super Fund here in Australia holds only about 2% of its portfolio in fixed income. On the simple premise that diversification is one of the most important principles of investing, that’s a dramatic imbalance and it can have a serious effect on a portfolio’s long-term performance.

In response to some client questions, this blog post is a “101” rundown on fixed income investing.

 

What is meant by ‘fixed income’?

‘Fixed income’ is often used as a very broad catch-all description for an asset class to include pretty much any kind of debt instrument, that is, where one entity borrows money from another. As you can imagine, that makes for a very large market. Some of the more common fixed income securities are:

  • Government bonds: these are bonds issued by the different levels of government in different countries. Just like a household, sometimes a government needs to borrow to fund its day to day running expenses. These can include everything from national governments (sovereign bonds) to state and local authorities (municipal bonds).
  • Corporate bonds: these are bonds issued by companies, usually big ones. This has become very popular since large companies can often get funding through the bond market more easily and cheaply than through a bank.
  • Asset-backed securities: these are when a bunch of loans get combined to form a single big lump of debt, which then gets broken up into tradeable parcels. It can cover a multitude of things like mortgage debt, credit cards, car loans – basically any deal where a person or entity owes someone or something money can be packaged up and sold off in bundles.

Another catch all expression that can be used is the ‘bond market’, which captures the fact that all these different securities can trade on secondary markets. So while one entity lends money to another, ownership of that debt obligation can be transferred to an entirely different entity, and can be traded many times over. Or it can be held to maturity, which is when the debt is due to be repaid.

 

Bonds compared to shares

The two most important characteristics of a bond is that it represents an obligation to pay someone interest on a loan, referred to as a coupon, and then to pay back the entire amount lent on a specific date – so a bond has finite life. Whether a share pays a dividend depends entirely on the discretion of the company’s board of directors, and is subject to fluctuation in line with how the company has performed; so dividends can go up and down dramatically while interest payments don’t change. And shares last in perpetuity, or for as long as the company lasts.

Corporate bonds can also have different levels of ‘seniority’, so if a company goes into liquidation, some bond holders will be repaid in priority to others. And most importantly, any kind of debt instrument will be repaid in priority to a shareholder, who has equity in a business.

It’s that added level of security that is the critical difference between bonds and shares: a shareholder gives money to a company in return for the chance to participate in how well the business does, so if a company’s profits go skyrocketing the shareholder will hopefully benefit from a rising share price. By contrast, a bond holder will only get the interest rate on the bond – the share price could triple and the bond holder’s return will not change at all.

At that point you might be thinking, why would I want to restrict my returns to just an interest rate? Well, it works the other way as well. So if a company’s shares halve, the bond holder’s returns will still not change. That level of certainty can be very appealing to offset the riskiness of a share portfolio.

 

What determines a bond’s price?

There are a couple of key determinants for a bond’s price: first is how risky is the issuer of the bond? A high risk borrower will have to entice lenders by paying a higher interest rate, and vice versa. This is where the ratings agencies, like S&P and Moody’s, play an important role.

Second, is the outlook for inflation. Since a bond is basically a promise to pay a string of future cash flows at a fixed level, if it looks like inflation is going up, then the lender will want to be compensated for that by receiving a higher price.

You may have heard the curious sounding expression that ‘bonds rallied sending the yield down’. A simplified explanation of how that works is that a bond will normally have a face value of $100. If it’s going to pay a coupon of 10%, then its price will be $90. If investors decide they really like that bond they will pay a higher value for it, sending the price up to, say, $95 which means the yield will go down to 5%. You simply need to remember that yield and price move in the opposite direction.

 

Part two…

Next week we’ll look at why bonds have performed so well over the past 30 years and why so many experts are arguing that’s set to change, and what role bonds have to play in a typical Australian investor’s portfolio.

This article reflects the views of the author and not necessarily the views of Steward Wealth.

This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product. You should seek advice from Steward Wealth who can consider if the general advice is right for you.

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