Two weeks ago, I said I was starting a series on investments. Start the series I did and little else. That was two weeks ago, and only now I am publishing this the 2nd Part, Fixed Income Investments.

The name fixed income is the term used in the financial industry, but rarely used outside of the industry. Fixed income as the name would suggest implies a fixed or determined income stream. Fixed income investments more simply stated are investments that pay interest. What really is interest though? Interest is nothing more than the fee charged for the privilege of borrowing money. At heart when anyone makes a fixed income investment, they are effectively lending money. I know when I go to the ATM and make a deposit into my savings account, I don’t think I’m making a loan. Yet, that’s exactly what I’ve done. I’ve loaned the bank money, and for that Citibank is willing to pay me interest. If I loan my friend money and charge him interest, I cannot easily sell that loan to someone else. However if I am able to package (securitize) that loan, i.e. put in some standard form that makes it easy to buy and sell then that loan becomes a bond. Corporations, governments, and rock stars issue bonds to borrow money.

Every fixed income has one part that will always be the same, the principal. The principal is just the money that is initially invested. What differs between fixed income investments are: term (time of investment), default risk, tax treatment and lastly the interest which is often determined by the other three factors. While there are dozens if not hundreds of different fixed income investments to be made, they can all be adequately described along those 4aforementioned axes. Below is my best representation of that 4 dimensional space as 3 dimensional abstract on 2 dimensional surface.

The interest paid on a fixed income investment is function of the term (length), credit quality (default risk), and tax treatment (tax exempt or non tax exempt). Generally speaking, the longer the term or the amount of time that you must lock up in an investment, the better the interest rate. That’s why a 5 Year CD is paying out something like 3.6% while a 1 year CD only pays out 3.5% today. The spread between the 5 year and 1 year CD is usually wider but the current economic conditions (i.e. a likely looming recession) have compressed that spread. The higher the risk that a borrower will default, the higher the interest rate required.

Some Typical Fixed Income Investments

  • Savings Account - Plain old savings account that pay a variable rate of interest, no restrictions on withdrawal
  • CDs - Certificate of Deposit. Bank issued certificates guaranteeing set level of interest for a set term for the same guarantee of term.
  • Treasury Bills and Bonds - Federal (U.S.) Government bonds of differing length
  • Corporate Bonds - Bonds issued by corporation. Credit Quality varies with the corporation
  • Municipal Bonds - Bonds issued by local governments are exempt from federal taxes (some are subject to AMT), and generally local taxes if owned by a local.

Most people think of fixed income investments as safe and conservative. Plain vanilla FDIC insured bank accounts and CDs would fall in that safe and conservative category. Fixed income investments unless the issuer defaults pays a guaranteed level of interest, no less no more. However when we talk about the more complex fixed income securities that trade, there can be both greater risk and reward because of the ability to buy and then resell that investment.

Let’s say for example I pay $1000 for a bond that pays $100 in interest a year. At the time of purchase I’m basically getting 10% in interest. One of the most important and basic principles to understand about bonds is the price of the bonds move inversely with the interest rate. The higher the interest rate, the lower the price and vice versa. Though the payment or coupon is fixed, the price of the bond is not. There is no guarantee someone else will pay me $1000 for that bond. Why can that be the case?

  • Prevailing interest rates rise or drop. Why would someone pay me $1000 for a bond when interest rates have gone up to 15% - someone could get a new bond that paid more. The only way to sell my bond is for me to the lower the price to $666.66 which would make the $100 coupon equivalent to a 15% return.  The same logic applies if interest rates drop to 5% but in reverse.   I would only sell my bond for $2000 knowing the $100 coupon is 5% of two thousand.
  • The credit quality of the issuer changes. Embedded into the price of debt is the risk that the entity borrowing the money will never pay back the principal or any of the interest. Companies and Government both face the risk of bankruptcy and that risk changes, and lenders demand to be compensated for that risk. As a result if I own a bond from company A and all of sudden it starts losing massive amounts of money, anyone I sold that bond would require that I lower the price enough (and therefore raise the interest payments) to compensate them for that risk.
  • Tax Law Change. Typically buyers of municipal bonds are willing to accept to lower interest rate payment because they aren’t paying taxes on the interest. So if all of sudden the income tax were eliminated Municipal bond issuers would not be able to offer lower interest payments and expect to compete

Individual investors are usually better of stick with the less riskier fixed income investments, CDs and Government Bonds. If as an investor you want to venture further, there are plenty of very well run bond mutual funds. Investing in individual corporate or municipal bonds is generally not cheap, and more complex.