fixed income fund, such as guaranteed investment certificates (GICs), bonds and money market instruments, usually generate predictable interest income or a future lump sum payment. Adding fixed income securities to your portfolio can be a great way to diversify it. Mutual funds and exchange traded funds are another way to access fixed income investments.
What are fixed income products?
When you buy stock, you are buying a stake in a company fixed income fund. But when you buy fixed income securities, you are lending money to the issuer. In essence, a fixed income security is an IOU that an issuer gives to investors. Fixed income securities can be issued by governments and corporations. In return for the money lent, you get a benefit – mostly in the form of regular interest payments until the money lent is fully repaid. The fixed-income security does not confer any right to participate in the profits of the issuer, unlike the action.
There are many types of fixed income securities, the best known of which are probably bonds. Bonds usually have a fixed term and promise a semi-annual coupon (payment of interest) to the lender.
You may be wondering why a corporation ends up borrowing money from ordinary people or why it doesn’t just issue shares to raise money. Companies sometimes take out a simple bank loan, but sometimes large companies need more funds than a bank can lend them. It is then that they turn to the markets and the investors.
The return you get from a fixed income fund is taxed differently than income from stocks. Capital gains and dividends receive favorable tax treatment, while interest from fixed income securities is taxed as income.
However, interest income is not the only income a fixed income security can generate. The price of a bond can change over time. When a bond’s price at maturity differs from its purchase price, you realize a gain or loss that can be treated as a capital gain or loss for tax purposes. This is also true if the bond was sold before maturity.
Similar bonds will offer approximately the same yields, even though they have different coupon rates.
Factors Influencing Fixed Income Securities
“Yield to maturity” is the term that expresses the return generated by a fixed income investment until its maturity, provided that its holder does not sell it before. It is established according to its purchase price and the interest (coupon) installments paid each year. Five major factors influence performance; here they are.
Interest rate.
Interest rates vary from market to market, and change over time based on government loan rates and market conditions.
Changes in benchmark interest rates and market rates significantly influence the price of fixed income securities. When market interest rates rise, bond prices fall. Conversely, when market interest rates fall, bond prices rise. That is to say, prices move in the opposite direction to interest rates. The best way to understand why bond prices and market rates move this way is to look at an example.
Suppose you buy a bond that bears interest at a nominal rate of 5.0% this year. Now imagine that interest rates fall during the year and that a similar bond is issued the following year at a nominal rate of 4.0%. The bond you own today is even more attractive because you receive a higher interest payment than an investor who buys a bond this year. Thus, the bond that bears interest at the nominal rate of 5.0% is worth more, because it pays interest above the market rate, and its price should rise.In this sense, similar bonds will offer approximately the same yields, even though they have different coupon rates. This is shown in the following table.