- The core principles surrounding fixed income are relatively simple. The “seller” of a fixed income security offers to pay the “buyer” for the use of the buyer’s money. The buyer is paid interest until the original investment amount is returned at the end of the investment’s term. The return of capital at the end of the term is subject to seller’s ability to meet this obligation.
- There are many types of fixed income investments, including government bonds, semi – government bonds, corporate debt, high yield credit and emerging market bonds. The term “fixed income” is a broad expression which covers instruments which pay both fixed and floating interest payments.
- An increase in the expected return from a fixed income investment is commensurate with an increased risk that some or all of your capital may not be returned to you at maturity. Some fixed income investments are “perpetual,” which means there is no set maturity date and they must be sold to another party to recoup some or all of the original capital invested. Below is a chart which shows the risk versus return across a series of traditional fixed income investments.
Risk versus Return across different fixed income investments
Source: Kapstream Capital
- The value of a bond can fluctuate on a daily basis due to a number of factors, including the future direction of future interest rates and the bond’s credit rating. Bonds that make fixed payments are the most sensitive to changes in market interest rates. Market interest rates in any country are generally the rate on the country’s 10 Year Government Bond. It does not refer to the official interest rate set by the domestic Central or Reserve Bank such as the RBA.
- For example, assume an investor purchases a bond for $100 which pays a fixed coupon of 5% or $5 per year. If market interest rate increases from 5% to 5.5%. The interest rate received on the actual bond cannot change to reflect the new market interest rate because it is fixed. Instead the price of the bond must change.
- The price of the bond would need to fall to around approximately $91 to provide the next purchaser with a yield of 5.5%, which reflects the market rate ($5 fixed interest payment / $91 purchase price = ~5.5%). The increase in the market interest rate has caused a loss on the bond of $9.
- The same principle applies when interest rates move in the opposite direction. If market interest rates fall, the price of the bond will rise to reflect the impact of the new interest rate. In summary, there is an inverse relationship between the price of a bond and the movement in the market interest rate.
Bond Price and Yield: Inverse Relationship
- The value of a floating rate investment is less sensitive to changes in market interest rates. This is because the interest rate on the investment can automatically adjust to the change in market interest rate. It would seem logical for investors to only invest in floating interest rate securities to limit the potential impact of interest rates on the value of their fixed income portfolio.
- The challenge with this strategy is that that the safest issuers of fixed income, such as major Governments, generally only issue fixed rate bonds. In our future updates we will take a closer look at the different fixed income sectors, their role in portfolios and the challenges achieving a satisfactory return in a low interest rate environment.