Fixed income: 10 things you should know
Many investors invest in fixed income investments as part of a diversified portfolio – but what is it all about?
1. Fixed income – also known as bonds and credit – is a commonly used type of debt investment. It is a type of ‘asset class’, meaning a category of asset into which an investor can invest.
2. Bonds are issued by governments or corporate entities seeking to raise funds. The issuer (also known as the borrower) sells a bond to an investor (also known as the lender) and the issuer promises to pay the principal back at the bond’s maturity date and to make regular fixed interest payments (called coupons), typically twice a year until (and including on) the final maturity date.
3. Types of bonds include:
- Government bond: issued directly by a government such as the Australian Commonwealth Government and guaranteed by the issuing government.
- Corporate bond: issued by large public companies to fund business growth or significant projects, or corporate actions (like a takeover). Corporate bonds do not carry a government guarantee, so they are generally riskier than Government bonds as there is increased credit risk (the risk the issuer will default on payment of coupons and principal). Due to this risk corporate bonds usually pay higher coupons than government bonds.
- SSA (Semi-government, Supranationals and Agencies) bonds: issued by entities such as State governments (for example, NSW issues debt through the state government guaranteed entity the NSW Treasury Corporation), semi-Government organisations (entities owned by a government with either an explicit or implicit government guarantee), and Supranationals (entities that are sponsored or supported financially by a group of two or more national governments, for example the World Bank and European Development Bank).
- Hybrid: an investment which exhibits characteristics of both fixed income securities and equities. For example, convertible bonds start as bonds but can be converted into equity at a future date. These types of securities typically carry more risk than corporate bonds as they rank lower in the capital structure than corporate bonds. If the issuer defaults on repaying the loan, investors in hybrids will only receive their money back after other security holders – higher up the chain – have received their money.
Did you know…The Australian Government has never defaulted on the interest payments on the bonds that it has issued or on the repayment of the principal amount invested in them. But the Argentinian Government has defaulted nine times since independence from Spain in 1816.
4. Some common terms relating to fixed income include:
- Coupon: the annualised interest rate that is paid (typically semi-annually) on the face value, expressed as a percentage.
- Credit rating: given to bonds and other debt investments by ratings agencies such as Standard & Poor’s or Moody’s on the basis of their risk. The scale ranges from AAA (the highest) through to C or D, depending on the agency. The top 4 ratings are considered safe, or ‘investment grade’, while lower ratings (BBB for Standard & Poor’s and Baa3 for Moody’s) are known as ‘high yield’ or ‘sub-investment grade’. In general governments have higher credit ratings than companies, reflecting that government debt is typically less risky (which causes it to typically deliver lower rates).
- Duration: a risk metric that describes how sensitive a bond is to a change in market yields. For example, a bond with a duration of 6 years will increase in value by 6% for every 1% fall in the market yield. Conversely the value will fall by 6% for a 1% rise in market yields. Maturity and duration are linked, with longer maturity bonds having higher duration and therefore being more sensitive to changes in market yields.
- Face value: the amount received at maturity.
- Maturity: the pre-set date at which the face value and final coupon is paid.
- Yield: the annualised return of the bond at its current price.
- Yield to maturity: the total return expected from a bond if the bond is held until its maturity date, and all payments are made as planned and reinvested at the same rate.
5. Many investors use fixed income (particularly government issued bonds) as a ‘defensive’ investment because it can help preserve capital, usually experiences less return volatility than shares and can pay a steady income stream through its regular coupon payments. It is viewed as lower risk than other asset classes such as equities and listed property.
6. Bonds can offer diversification benefits because they often perform well when shares perform poorly, which means that bond investments help to lower total risk within a diversified portfolio.
7. The total return on bonds comprises income from coupon payments plus any growth or loss from price fluctuations. The price or value of a bond, with fixed coupon payments, increases as the yield-to-maturity declines and vice versa.
8. The Australian bond market (government and corporate issues) is worth $958 billion1 in Australian dollars, while globally the bond market is worth $167 trillion Australian dollars2.
9. You can access bonds directly or through a managed fund. The benefit of a managed fund is that it can hold hundreds, sometimes thousands, of securities which allows it to achieve significantly higher diversification than most individual investors. This means that if there is a default on one security, the impact on the investor is lessened given the high number of other securities held in the portfolio.
10. The Schroder Fixed Income Fund provides a cost-effective way of accessing a highly diversified portfolio of bonds, which can include a mix of Australian or international government and corporate bonds, or a combination of both.
1 Source: Australian Securities Exchange (ASX) Bond Monthly Update – December 2020.
2 Source: International Capital Market Association (ICMA) Bond Market Size as at August 2020. Note the figure quoted by this organisation is in US Dollars and has been converted to Australian dollars using the exchange rate of 1 AUD = 0.7645 USD sourced from the Reserve Bank of Australia as at 29/1/21.
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