Definition: Fixed income means investments that pay a known schedule of income. The most common are bonds: you lend money to a government or company, it pays you interest (the coupon) and gives the money back on a set date (the maturity).
Explanation
Key words.
- Face value (par): the amount repaid at maturity, often $1,000 per bond.
- Coupon: the interest paid each year, as a percentage of face value.
- Maturity: the date the bond is repaid.
- Yield: the return you get if you buy the bond at today’s price and hold it to maturity.
Prices and yields move in opposite directions. A bond’s coupon is fixed. If interest rates in the market go up, new bonds pay more, so older bonds with lower coupons are worth less and their price falls. If rates go down, older bonds become more valuable.
A bond’s price is the value today of all its future payments:
where is the coupon payment, the face value, the yield and the number of years.
Main risks.
- Interest rate risk: prices fall when rates rise. Longer bonds are hit harder. Duration measures this sensitivity.
- Credit risk: the borrower might not pay. Rating agencies grade this (for example AAA down to D).
- Inflation risk: fixed payments buy less if prices rise.
Main types. Government bonds (such as US Treasuries or UK gilts), corporate bonds, municipal bonds and mortgage-backed securities.
Link to central banks. Changes in Monetary Policy move bond yields, and central banks buy and sell government bonds in Open Market Transactions.
Examples
A bond losing value when rates rise. A 10-year bond has a face value of $1,000 and a 5% coupon, so it pays $50 a year. If market yields for similar bonds rise to 6%, the bond’s price falls to about $926 (using the formula above with yearly coupons), because buyers can now get $60 a year from a new bond.
2022. As central banks raised rates quickly, bond prices fell sharply and many bond funds had their worst year in decades.