What it means
When you buy a fixed income security you are lending money rather than owning a slice of a business. The borrower, called the issuer, agrees to pay interest at stated intervals and to repay the face value on a stated maturity date.
Governments, companies, banks and local authorities all issue fixed income to fund themselves, and the size of these markets globally exceeds that of the stock markets. For a business, fixed income is the other side of the funding conversation.
Issuing a bond is often cheaper than bank borrowing for large, established companies, and it locks in a rate for a long period without the covenant burden of a typical loan facility. For treasurers with surplus cash, short-dated fixed income is where money sits between operating needs, because it earns a return without the volatility of equities.
The central mechanic that confuses newcomers is the inverse relationship between price and yield. If you own a bond paying $50 a year and new bonds start paying $70, nobody will buy yours at full price, so its market value falls until the effective return matches what is available elsewhere.
Rising interest rates therefore reduce the value of existing fixed income holdings, and the longer the remaining term, the sharper the fall. The second thing to understand is credit risk, meaning the chance the issuer fails to pay.
Government bonds from stable countries are treated as the safest end of the scale, corporate bonds pay more because they carry more risk, and high-yield bonds pay considerably more because default is a real possibility. Rating agencies grade this risk with letter scales, and the gap in yield between a risky issuer and a safe one is called the credit spread.
Not all fixed income is literally fixed. Floating rate notes reset their coupon periodically against a reference rate, index-linked bonds adjust payments with inflation, and some instruments allow the issuer to repay early, which caps the investor's upside.
The category name survives because the payment terms are contractually defined in advance, even when the amount can move.
In practice
Real-world examples.
Example
A charity with a $3,000,000 reserve fund needs predictable income to cover salaries. It builds a ladder of bonds maturing in one, two, three, four and five years, so a portion matures each year and can be reinvested at whatever rates prevail then.
Example
A utility company issues $400,000,000 of ten-year bonds at 4.8% to fund a grid upgrade. Because the revenue from regulated tariffs is highly predictable, investors accept a yield only slightly above government bonds of the same maturity.
Example
A treasury manager holding long-dated bonds watches the portfolio's market value drop 9% after a sharp rise in central bank rates. Because the company intends to hold the bonds to maturity and the issuers remain sound, the fall affects the reported valuation but not the cash the business will actually receive.
Formula
Calculation
Current Yield = (Annual Coupon Payment / Current Market Price) x 100
Annual Coupon Payment = Face Value x Coupon Rate
Worked example. A corporate bond has a face value of $1,000 and a coupon rate of 5%, so it pays:
Annual coupon = $1,000 x 5% = $50 per year.
If you buy the bond at its face value of $1,000, the current yield is $50 / $1,000 = 5.00%, the same as the coupon rate.
Now suppose market interest rates rise and the bond's price falls to $800 in the secondary market. For a new buyer:
Current yield = ($50 / $800) x 100 = 6.25%.
The coupon has not changed at all; the buyer simply pays less to receive the same $50 a year. An investor putting $80,000 into this bond at $800 each would buy 100 bonds, receive 100 x $50 = $5,000 of coupon income a year, and would also collect $100,000 of face value at maturity, giving a capital gain of $20,000 on top of the income if the issuer repays in full.Case study
Seen in the real world.
The following is a fictional, illustrative scenario. Bramfield Housing Trust held $12,000,000 of reserves and invested almost all of it in twenty-year corporate bonds because the yields were the highest available and the trustees wanted maximum income. Annual coupon income of roughly $600,000 funded a quarter of the trust's operating budget, and for three years the arrangement worked exactly as planned.
When market interest rates rose by two percentage points over eighteen months, the market value of the portfolio fell to around $9,300,000. The coupons kept arriving untouched, but the trust's auditors required the holdings to be reported at market value, and a planned property purchase suddenly meant selling bonds at a substantial loss rather than at face value.
The trustees restructured toward a ladder with maturities spread from one to seven years, accepting a lower average yield in exchange for regular access to cash at face value. In this illustrative case nothing about the credit quality of the issuers had changed; the problem was purely a mismatch between a twenty-year investment horizon and a three-year spending plan.
Watch out
Common mistakes.
- Believing fixed income cannot lose money. The coupon is contractually fixed, but the market price moves with interest rates and credit quality, so selling before maturity can crystallise a real loss.
- Chasing the highest yield without checking the issuer. An unusually high yield is the market pricing in an unusually high chance of default, not a bargain that other investors have somehow missed.
- Confusing the coupon rate with the yield. The coupon is a fixed percentage of face value, while the yield depends on what you actually paid, and the two only match when the bond trades at par.
Questions
People also ask.
What is duration and why does it matter?
Duration measures how sensitive a bond's price is to interest rate changes, and a longer duration means a bigger price move for the same shift in rates.
Is fixed income safer than shares?
Generally yes in terms of price volatility and because bondholders rank ahead of shareholders if a company fails, but low-rated corporate bonds can be riskier than shares in a stable, profitable company.
Can a business issue fixed income if it is not listed?
Yes, private placements and unlisted bond issues are common for mid-sized companies, though they typically require a larger minimum size and carry higher yields than public issues.
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