Fixed income: Explained

BY TIO Staff

|July 12, 2024

In the world of trading, "fixed income" is a term that is frequently used but often misunderstood. It refers to a type of investment in which the borrower is obliged to make payments of a fixed amount on a fixed schedule. This includes government and corporate bonds, certificates of deposit, and preferred stock, among other things. The term "fixed income" can also refer to a person's income that does not fluctuate, such as a pension.

Fixed income investments are typically considered safer than stocks, as they offer a steady stream of income. However, they also come with their own set of risks and rewards, which we will delve into in this glossary entry. Whether you're a novice trader or a seasoned professional, understanding the ins and outs of fixed income can help you make more informed investment decisions.

Understanding Fixed Income

At its core, a fixed income investment is a loan made by an investor to a borrower. The borrower, which could be a government, municipality, or corporation, issues a bond that states the terms of the loan, including the interest rate (also known as the coupon rate), the dates on which the interest payments will be made, and the date at which the borrowed amount (the principal) will be returned (the maturity date).

Fixed income investments are often used by investors who want to generate a steady stream of income. The predictable nature of these investments makes them a popular choice for retirees, or for those who are looking to minimize risk in their portfolio. However, like all investments, fixed income securities come with their own set of risks.

Types of Fixed Income Securities

There are several types of fixed income securities, each with its own set of characteristics and risks. Government bonds, or treasuries, are considered the safest type of fixed income investment, as they are backed by the full faith and credit of the U.S. government. Corporate bonds are issued by companies and carry a higher risk, but also offer higher potential returns. Municipal bonds are issued by states, cities, and other localities, and offer tax advantages to investors.

Other types of fixed income securities include mortgage-backed securities, which are backed by mortgage loans, and preferred stock, which gives holders a higher claim on earnings and assets than common stockholders. Each type of fixed income security offers a different level of risk and return, and the best choice for an investor will depend on their individual goals and risk tolerance.

Risks Associated with Fixed Income

While fixed income investments are generally considered safer than stocks, they are not without risk. One of the primary risks associated with fixed income investments is interest rate risk. When interest rates rise, the price of existing bonds falls. This is because new bonds are issued with higher coupon rates, making the older, lower-yielding bonds less attractive to investors.

Another risk associated with fixed income investments is credit risk, or the risk that the issuer will default on their payments. Government bonds have the lowest credit risk, while corporate bonds have a higher risk. Inflation risk, or the risk that inflation will erode the purchasing power of the fixed payments, is another concern for fixed income investors.

Trading Fixed Income

Trading fixed income securities involves buying and selling these investments on the open market. Traders can profit from price differences and interest payments, but must also navigate the risks associated with these investments. Understanding the factors that influence the price of fixed income securities, such as interest rates and credit ratings, is crucial for successful trading.

Fixed income trading can be done through a broker or on an electronic trading platform. The market for these securities is large and liquid, making it easy for traders to buy and sell a wide range of fixed income products. However, the complexity of these products and the risks associated with them make it important for traders to have a solid understanding of the fixed income market.

Strategies for Trading Fixed Income

There are several strategies that traders can use when trading fixed income securities. One common strategy is to buy and hold, where the trader buys a bond and holds it until maturity, collecting the interest payments along the way. This strategy is best for those who want a steady stream of income and are not concerned about price fluctuations.

Another strategy is active trading, where the trader buys and sells bonds to take advantage of price fluctuations. This strategy requires a deep understanding of the factors that influence bond prices, as well as the ability to react quickly to market changes. Other strategies include laddering, where the trader buys bonds with different maturity dates to spread out risk, and barbelling, where the trader buys short-term and long-term bonds but avoids those with medium-term maturities.

Tools for Trading Fixed Income

There are several tools that can help traders navigate the fixed income market. These include bond calculators, which can help traders determine the yield, price, and duration of a bond; bond ladders, which can help traders manage risk by spreading out their investments over different maturity dates; and bond indices, which provide a benchmark for comparing the performance of a bond or a portfolio of bonds.

Additionally, many trading platforms offer research and analysis tools that can help traders make informed decisions. These tools can provide information on the creditworthiness of bond issuers, historical price data, and forecasts for interest rates and inflation. Using these tools effectively can help traders maximize their returns while minimizing risk.

Conclusion

Fixed income is a crucial part of the financial market, offering a steady stream of income for investors and a source of funding for governments, municipalities, and corporations. While these investments are generally considered safer than stocks, they come with their own set of risks and rewards. Understanding these factors is crucial for anyone involved in trading fixed income securities.

Whether you're a novice trader looking to diversify your portfolio, or a seasoned professional seeking to maximize your returns, a deep understanding of fixed income can help you navigate this complex market. By understanding the different types of fixed income securities, the risks associated with them, and the strategies for trading them, you can make more informed investment decisions and increase your chances of success in the world of fixed income trading.

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TIO Staff

Behind every blog post lies the combined experience of the people working at TIOmarkets. We are a team of dedicated industry professionals and financial markets enthusiasts committed to providing you with trading education and financial markets commentary. Our goal is to help empower you with the knowledge you need to trade in the markets effectively.