Learn About Fixed Income

Learn About Fixed Income

First of all, what is Fixed Income?

Fixed income is a type of investment in which real return rates or periodic income is received at regular intervals and at rationally predictable levels.

Investors use fixed income to diversify their portfolios, as they pose less risk than equities and derivative investments. Retired individuals typically tend to invest heavily in fixed-income investments because of the reliable returns they offer.

What about Fixed Income Trading?

Fixed income trading is the process of trading fixed income securities over-the-counter (OTC).  The fixed income market has low transaction costs, a competitive market structure, and various market participants. The fixed income securities market is led by institutional investors.

And Fixed Income Securities?

A fixed income security or a debt security is a claim on a particular periodic income stream. Fixed income securities are named so because they guarantee a stream of income determined by a formula or a fixed stream of income.

Factors affecting trading in the fixed income market

Below are the factors that affect fixed-income trading:

  • Credit/Default Risk

Credit/default risk arises if the issuer of a security is unable to pay interest and/or principal in a timely fashion, and to comply with the provisions of a bond indenture.

  • Interest Rate Risk

There is a negative correlation between the price of debt securities and interest rates. However, there is a positive relationship between interest rate and yield. Interest rate risk arises when an adverse change in the interest rate has a similar adverse impact on the yield of debt securities.

  • Reinvestment Rate Risk

This refers to the probability of a decline in the interest rate, causing a decline in the options available for investing the interest income received at higher or similar rates in the market.

  • Counter-party Risk

The failure of the opposite party to the contract to deliver the sale value or the promised security at the time of settlement leads to counterparty risk.

  • Price Risk

Price risk occurs when the investor does not receive the expected price due to an adverse movement in prices.

Learn About Fixed Income 2

Why invest in fixed income securities?

To achieve different goals, an investor can invest in different types of fixed income securities:

  • Capital Appreciation

Those aiming to make capital gains should primarily invest in low-rated securities like emerging market debt or high yield bonds. If interest rates are likely to fall, investing in government bonds and long-term maturity corporate bonds also lead to capital gains.

  • Income

All fixed income securities provide some form of income for the investors. However, if the investor is not particularly risk-averse, they can invest in mortgage-backed securities and/or corporate bonds if earning an income is their primary goal.

  • Safety

Risk-averse investors seeking safety investments should invest in securities with short maturity periods to reduce interest rate risk and in securities with a high credit rating to avoid default risk.

  • Tax Advantages

Those seeking to maximize their after tax-income should invest in municipal bonds as they are tax-free (most of the time).

See Also: Investment Risk: Its Definition and its Types

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