What it means
The defining feature is a promise. The issuer agrees to pay interest, usually called the coupon, on set dates and to repay the face value at maturity, which makes the cash flows predictable in a way that share dividends never are.
Predictable is not the same as safe. Two main risks remain: the issuer may fail to pay, which is credit risk, and market interest rates may rise, which pushes the price of an existing bond down because newer bonds now pay more.
That inverse relationship between rates and prices confuses newcomers more than anything else. If you hold a bond paying 4% and fresh bonds are being issued at 6%, nobody will buy yours at face value, so its market price falls until the return on offer matches the new level.
Fixed income sits in portfolios for income and for ballast. Pension funds and insurers hold it to match known future obligations, and cautious investors hold it because bond prices have historically moved differently from share prices, softening the overall swings.
The label is looser than it sounds. Floating rate notes, index linked bonds and preference shares are all classed as fixed income even though their payments vary, because the investor holds a creditor style claim rather than an equity stake.
In practice
Real-world examples
Example 1
A retired investor puts $200,000 into a ladder of government bonds maturing one year apart, generating roughly $9,000 of annual interest at an average coupon of 4.5% and returning a slice of capital each year to reinvest or spend.
Example 2
A manufacturer issues $50,000,000 of ten year bonds at a 6% coupon rather than borrowing from a bank, committing to $3,000,000 of interest every year and a single $50,000,000 repayment in year ten.
Example 3
An insurance company holds long dated bonds to match claims it expects to settle in twenty to thirty years. When interest rates fall the market value of those bonds rises, but so does the present value of the claims, so the quality of the matching matters more than the price move on its own.
Think of it
Lending money to a friend who promises to pay you back five pounds every month for a year, and then returns your original hundred pounds on New Year's Eve.
Formula
Calculation
Coupon payment = face value x coupon rate
Current yield = annual coupon / market price
Approximate yield to maturity = (annual coupon + (face value - price) / years to maturity) / ((face value + price) / 2)
An investor buys a corporate bond with a $1,000 face value, a 5% annual coupon and five years to maturity, paying $960 because market rates have risen since the bond was issued.
The annual coupon is $1,000 x 5% = $50, so the current yield is $50 / $960 = 5.21%. Over the five years the investor collects 5 x $50 = $250 in coupons plus a $1,000 - $960 = $40 gain at redemption, giving $290 of total return on a $960 outlay.
The approximate yield to maturity is ($50 + $40 / 5) / (($1,000 + $960) / 2) = ($50 + $8) / $980 = $58 / $980 = 5.92%, comfortably above the 5% coupon because the bond was bought at a discount to its face value.Case study
Seen in the real world
The following is an illustrative and entirely fictional example. The Rowanhurst Foundation, an invented charitable endowment, held $12,000,000 in long dated bonds paying an average coupon of 3%, generating $12,000,000 x 3% = $360,000 a year to fund its grant programme.
When market yields rose from 3% to 5%, the trustees were alarmed to watch the portfolio's market value fall by roughly 20%, to about $9,600,000, and one trustee proposed selling before it dropped further.
The finance committee pointed out that the foundation had no need to sell anything: the coupons were unaffected at $360,000 a year, and every bond would repay its full face value at maturity. In this illustrative case the paper loss mattered only for the annual report, and the real news was that fresh money could now be invested at 5% rather than 3%, lifting future grant income by two thirds for every dollar reinvested.
Watch out
Common mistakes
- Assuming fixed income means no risk, when default and interest rate movements can both produce very real losses.
- Being surprised that a bond's price falls when interest rates rise, which is arithmetic rather than misfortune.
- Judging a bond by its coupon rather than its yield, which reflects the price actually paid and the time left to maturity.
Questions
People also ask
Is a bond fund the same as holding bonds directly?
No, a fund has no maturity date of its own, so a rise in rates produces a loss that is not automatically recovered by waiting for a fixed redemption.
What is the difference between coupon and yield?
The coupon is a fixed percentage of face value, while the yield expresses the return relative to the price you paid and how long you must wait for repayment.
Are preference shares really fixed income?
They behave like it, paying a set dividend ahead of ordinary shares, but they rank below debt if the company fails and the dividend can usually be skipped without triggering default.