What is Fixed Income and How Does it Affect the Economy?

What is Fixed Income and How Does it Affect the Economy?

Fixed income implies an investment wherein the payments are made on a fixed schedule and of a fixed amount, either by the issuer or the borrower.

However, it can also be used in another sense. This term can also be applied to an income that is derived from pensions or preferred stocks which are all fixed income sources. They do not vary.

What is Fixed Income Investment?

Fixed-income investment offers a determined or fixed rate of return. Here, the interest is generated over a defined period. Since it offers fixed returns on investments, they are considered better than derivatives and equities.

What are the Benefits of Fixed Income?

Below mentioned are some of the benefits linked to fixed income.

1. Lower Risk: Since they offer a fixed amount of return on investments, they are less prone to risks as compared with stocks. A major reason that works behind this is that fixed-income assets do not generally get much affected by macro-level variations.

In case, you hold a major amount of stocks in your portfolio, you can allocate some of it to fixed-income investments. By allocating a part of your portfolio to fixed-income investments, you can escape huge losses such as major fluctuations in stocks.

2. Capital Preservation: Capital preservation refers to safeguarding your investment’s absolute worth through assets that have a defined return of principal goal. It is highly recommended for investors who are near to getting retired to go for fixed income investments as it carries less risk. Because they do not have much time to cope with the losses, this can serve as a source of income for them.

3. Income Generation: Since they offer a fixed return on investments, they can provide you with a consistent source of income.

4. Total Returns: Some fixed-income securities have the potential to produce high returns. Taking on additional credit risk or interest rate risk can help investors earn bigger returns.

What are the Risks Associated with Fixed Income?

Below mentioned are the 4 major risks linked to fixed income.

1. Interest Rate: The bond prices will fall in case the interest rate rises. This will lead to a fall in the value of your bonds.

2. Inflation: Though fixed income investing offers a fixed rate of return; a problem can arise if the pace of the inflation rate outpasses fixed income.

3. Credit Risk: When you buy corporate bonds, you’re taking on credit risk as well as interest rate risk. The danger of an issuer defaulting on its debt obligations is referred to as credit risk. This way, the investor might fail to receive the principal investment’s full value.

4. Liquidity Risk: An investor is said to be suffering liquidity risk if they want to sell a fixed income asset, but they cannot find someone who would like to buy.

Types of Fixed Income

1. Short-Term

This type of fixed income offers low-rate returns. This is because you are required to invest money only for a few months. Low returns are also a reason why many of the investors shifted from short-term to longer-term investments.

It is used to cope with the cash flow required to main day-to-day operations.

  • Savings Account: Based on the fed fund rate, you’re offered a fixed interest rate. You are free to withdraw whenever you feel like it.
  • Money Market Accounts: Here, the rate of interest is a bit higher than that of the savings account. But, you’re required to keep a certain amount deposited. The drawback here is that the number of transactions that can be made in a year is limited.
  • Certificates of Deposit: Here, you are required to keep your money invested for a desired period to get the predetermined rate of return.
  • Money Market Funds: These are a type of mutual funds that are found to invest in short-term investments. Based on short-term securities, you are paid a fixed rate. It comprises- treasury bills, federal agency notes, and eurodollar deposits.
  • Short-term Bond Funds: These are mutual funds that invest in one-year to four-year bonds.

2. Long-Term

This investment is also known as a bond. It implies an arrangement of debt between two parties- the issuer and the investor. The interest rate is largely dependent on treasury rates, and credit and duration risk that come up with the issue.

Below mentioned are the types of bonds.

  • Government Bonds: These are the safest and the most secure bond because they are guaranteed. This is the reason why they offer the lowest return.
  • Corporate Bonds: They offer a slightly higher rate. These are usually sold by the companies whenever they require cash, but at the same time, do not want to issue stocks.
  • Convertible Bonds: As is obvious by the name, these bonds can be converted to stocks.
  • Eurobonds: This is another name for eurodollar bonds. These are foreign bonds that are not denominated in the domestic currency of the market in which they are issued. For instance, Asian companies issuing bonds in South Africa are denominated in U.S. dollars.

3. Fixed Income Derivatives

Many financial derivatives have their value based on fixed-income products. These are used by big investors and companies to escape losses.

  • Options: An option can be defined as a derivative contract that gives the buyer the authority to trade a bond at a fixed price within a certain amount of time. A buyer is authorized by options for the same. They are exchanged on a regulated market.
  • Future Contracts: These are similar to options. The only difference that exists between them and options is that here the buyer is bound to execute the trade. They are traded on an exchange.
  • Forward Contracts: These are again similar to future contracts. The only difference that is found between future and forward contracts is that they are not traded on an exchange. The process that is followed here is Over The Counter (OTC) which can even be between two parties or via a bank.
  • Mortgage-Based Securities: They’re worth a lot of money because they’re made up of a bunch of house loans. They provide a rate of return based on treasury rates as well as the risks specific to the underlying assets, similar to a bond.
  • Collateralized Debt Obligations: These are made up of a variety of underlying assets. These may include- corporate bank loans, auto loans, and credit card loans.
  • Asset-Backed Commercial Paper: These are corporate bond packages with a period of one year. They comprise real estate, corporate auto fleets, and other business property.
  • Interest Rate Swaps: Interest rate swaps are derivative contracts. It’s an agreement between two parties to swap all future interest rate payments from a bond or loan. It occurs among companies, banks, or investors.

Third-Party Fixed Income Payment Streams

Some fixed income streams do not depend on the amount of investment. A third party guarantees the payment here.

  • Social Security: These are available once a certain amount of time has passed. It’s backed by the federal government and calculated using the taxes you’ve paid. The Social Security Trust Fund is in charge of it.
  • Pensions: Based on the number of years you worked as an employee and your salary, your employer assures you a fixed payment after you retire. Very few companies and sectors are found to serve this benefit these days.
  • Fixed-Rate Annuities: These are insurance products that guarantee a fixed payment over a set length of time. As a result of fewer workers receiving pensions, these are on the rise.

How to Invest in Fixed Income?

As an individual, you can invest in fixed income via mutual funds and exchange-traded funds.

An individual investor can also possibly buy a single bond or any other fixed-income security. This way, you’re required to have a significant amount of assets to get a diversified portfolio of individual bonds built.

However, there are some hurdles that individual investors often face while investing in fixed income. These include- high minimum investment requirements, high transaction costs, and less liquidity in the bond market.

Its Impact on the Economy

The impact of fixed income on the economy can be described as-

Bond markets are used by companies to raise capital to expand their business and to grow. They receive the cash they need for day-to-day operations by using money market instruments.

Money market instruments refer to securities that offer large capital at a low cost to businesses, banks, and the government for a short period.

For other interest rates, they go for treasury bills, notes, and bonds. Treasury bills and the output are inversely proportional. When the demand for treasury bills falls, the output tends to rise. Then, higher interest rates are demanded by the investors on other fixed-income products.

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