October 12, 2023

Fixed Income: The basics explained

Fixed Income, also known as bonds, is a key ingredient of a diversified investment portfolio. Let's go over the basics

The basics of fixed income or bonds

Governments get income from taxes, and listed companies can raise money through the issue of more shares, so why do they go to fixed income, better known as the bond market, to raise debt?

Quite simply, governments can’t continuously raise taxes and investors get fatigue if a corporate constantly asks for more equity by issuing shares. In the latter case, existing shareholder positions are also diluted unless shareholders participate in each capital raising.

It’s also not a bad thing to carry debt on a balance sheet, as it provides the borrower with greater flexibility to meet its capital needs, particularly if conditions are favourable and money is relatively cheap compared to the returns the borrower expects to generate with the funds.

Traditional lenders like banks only have so much funding available to lend, and certainly not enough to meet all the requirements of governments and business, after all, the global bond market in 2022 totalled $US133 trillion, according to the World Economic Forum1.

With the share market, investors may be looking for a return from share price appreciation, dividends, or both. Bonds can provide capital growth but typically it is an investment in return for regular interest payments and the return of the initially invested capital after an agreed amount of time.

A bond is similar to a personal loan, only in this case you and other investors participating in an issue play the role of the ‘bank’ providing the loan to a government or corporate.

The purpose of markets

Whether it’s a bond or equity market, the existence of those markets is the same – to provide for the transfer of funds from those seeking a monetary return on their capital to those who need capital to grow, innovate and bring concepts to development.

Bonds can offer specific advantages to those seeking to preserve and protect capital.

Bond basics 

When a bond is issued it comes with terms and conditions. They spell out the interest rate (coupon) to be paid periodically on the bond, typically every 3, 6, or 12 months. The terms also state the date the bond will mature, which is when initial funds invested are returned. Additional information will include the purpose of the bond, and any specific conditions which apply if there is a default event.

Bond issues are rated by at least one of the three major independent international ratings agencies – Moody’s, Standard & Poor’s, and Fitch. For corporate bonds the strongest and safest companies will fall into the investment grade category. The ratings agencies give this rating when they consider the chance of default remote. Investment grade bond defaults are rare events, but they do form part of the risk matrix of the bond market.

Ratings outside of this band are termed high-yield bonds. Like any investment the higher the risk the greater return, so investors go to high-yield bonds when they want to squeeze a bit more yield out of their investment in return for accepting that the bond they invest in is carrying higher default risk.

It should be noted the risk of default increases during periods of economic turbulence and rising interest rates, as lower quality corporates may have difficulties meeting debt commitments or rolling over bonds to meet ongoing funding requirements.

In a worst-case scenario where a corporate collapses, traditional bonds are given higher priority for any capital return over shares.

Investors add bonds to their portfolio to get secure income, add asset class diversification to help smooth out portfolio returns over the long term (you can find out more about diversification here) and to lower overall risk within a portfolio. On a rising risk scale, bonds sit above cash but generally below other main asset classes, including equities and property.

The bond universe is huge

We have only touched on the basics of bonds. Bonds come in many forms. Apart from investment grade and high yield bonds there are hybrids (containing elements of bonds and equities), capital notes, mortgage-backed bonds, and so on. Bonds also come in different forms, like fixed and floating rate bonds. You can find out more about how bonds fit in a portfolio here.

Bonds can also be sold before maturity if you need to free up cash for another opportunity. If a bond is ASX listed it can be sold on the exchange, otherwise a bond would be sold on the over-the-counter (OTC) market. If you have not invested in bonds, you may not have heard of the OTC market, but it is much larger than the ASX listed bond market.

Conclusion

It’s worth taking the time to learn more about bonds and how they can benefit an investment portfolio. Monitoring the performance of most bonds like a share price would be a dull and mostly pointless exercise, and that’s a good thing. The job of a bond is to provide income and security, not the excitement and gyrations of listed equities. But given the size and scope of available bonds, it still takes time to understand the bond that will best suit your requirements.

Our investment specialists are always on hand to answer any questions you have and discuss options available to meet your needs.

 

The information contained in this article is gathered from multiple sources believed to be reliable as of the end of September 2023 and is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, we recommend that you consider whether it is appropriate for your circumstances and that you seek independent legal, financial and taxation advice before acting on any of this information. ©2023 NAB Private Wealth is a division of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit Licence 230686.

 

 

1 Ranked: These are the largest bond markets in the world | World Economic Forum (weforum.org)

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