As a staple of most portfolios, understanding fixed income is crucial to meeting investment objectives: Learn the fundamentals here.
Fixed-income securities are a mainstay of investor portfolios. While they come in many shapes and sizes, bonds and other fixed-income securities are simple in principle—they’re loans from the investing public to an institution that needs money. Issuers of the bonds are the borrowers and investors are the lenders. Investors who lend the money expect to be repaid and they expect to be compensated for the use of their money and the risk they take in making the loan. Investors’ compensation—the interest on the loan—often takes the form of a regularly paid coupon, say, 5% per year. It’s this coupon payment—a consistent, repeating cash flow—that gives fixed income its name.
The fact that bonds provide a steady cash return and eventually repay all of the original capital (assuming all goes well) gives them a unique role in a portfolio—they provide a steady flow of returns with lower volatility than equity. However, for years, bonds have been used as a counterbalance to equity investments for another reason: Historically when stocks go down, bonds often go up.
But wait a minute, why do bonds “go” anywhere? Don’t they pay regular coupons, as well as return the principal?
In fact, the value of the bond changes over time. Imagine that a hypothetical bond’s 5% coupon perfectly compensates the investor at the time of issue. The investor receives 5 pounds per year for the 100 pounds initially lent. But if inflation shoots up unexpectedly by 2% the year after the bond is issued, the same company might issue nearly identical bonds with a 7% coupon. Suddenly last year’s bonds with their 5% coupons don’t look very attractive to investors. Since the coupon is fixed at 5%, the only thing that can reflect the bond’s disadvantage is its market price, which, in this example, will go down—let’s say to 98 pounds. Again, the point here is that while the coupon of the bond is fixed, the bond’s value on the market—and in your portfolio—is not.
The relationship of a bond’s coupon to its current market price is captured in its yield. In our example, the yield of the bond paying the 5% coupon at the time it was issued was also 5%. But when the bond’s market value went down from 100 pounds to 98 pounds, the bond’s yield went up. Intuitively we know that the 5 pound coupon is more than 5% of the new, lower 98 pound value. The math is a bit more complicated than this, but the idea is that the yield of the bond expresses the value of the coupon payments relative to the current market price of the bond. When the bond’s market price goes down, its yield goes up, and vice versa.
In this example, the value of the bond declined due to inflation, which is just one aspect of interest rate risk. A bond’s sensitivity to interest rates is a major risk factor for fixed-income securities, and it has a name: duration. Duration can vary dramatically from bond to bond, depending on maturity, the size of the coupon payments and other factors. Higher duration figures indicate greater interest-rate risk.
Duration conveys how much the value of the bond will change relative to an overall change in the interest-rate environment. A duration of 4.3, for example, means that the value of the bond should decrease 4.3% for each 1% increase in interest rates. While duration provides important insight into a bond’s interest-rate risk, it’s only an estimate. (See Interest-Rate Risks” and “Understanding Duration” for more information.)
Interest-rate risk is hardly the only concern for fixed-income investors. A more basic risk is also at play; namely, that the borrower won’t actually pay you the money owed, whether it’s the principal or a coupon payment. Credit risk is described in its broadest sense as either investment grade (less credit risk) or high yield (more credit risk). Bonds also carry credit ratings that provide a finer distinction of credit risk; namely, a letter-grade system that denotes many different levels of risk within investment-grade and high-yield buckets. While the reputation of credit ratings and the ratings firms themselves suffered during the 2007/2008 financial crisis, credit ratings are both widely followed and not fully believed. (See “Understanding Credit Quality And Issuers.”)