Fixed Income
March 2, 2021
What is “Fixed Income”?
The term fixed income in finance refers to any type of instrument where the issuer (i.e., the borrower) will pay a set of pre-determined, fixed cash flows at pre-determined points in time. Typically, these cash flows will be ongoing interest payments, often referred to as coupons. and the principal. The issuer (borrower) of the fixed income instrument is contractually obliged to make these payments. If the issuer fails (defaults), there is a risk that payments will not be made in full. Typical examples of fixed income instruments are government bonds and corporate bonds (both investment grade and high yield).
In contrast to this, a common share is a great example of a non-fixed income instruments. Holders of common shares will receive dividends of an unknown size, at an unknown time in the future, and only if the company has enough cash flows to support them. Companies are not contractually obligated to pay dividends to common shareholders.
Key Learning Points
- Fixed income instruments are instruments that pay cash flows of a pre-determined size at a pre-determined time.
- Issuers of fixed income instruments are contractually obligated to make the agreed payments.
- Fixed income instruments are issued by both sovereigns and corporates.
- As the cash flows are “known” the great unknown is the discount rate
Discount Rate
As the future cash flows are known in fixed income, the value of the instrument will simply be the present value of the cash flows. As such, the discount rate is the main unknown factor determining the value of a fixed-income instrument. As a rule, discount rates will be higher as the risk of the issuer defaulting increases. Bonds issued by governments (sovereign bonds), are usually considered risk-free, at least in developed markets. This means that we expect the issuer to pay the future contractual cash flows in all circumstances. Therefore, the discount rate used to price them will be considered the risk-free interest rate. The risk-free interest rate is driven by things like central bank policy or inflation expectations.
When the issuer is non-sovereign, like a company, there is a risk that the cash flows may not be paid. In this case, a higher discount rate will be used to reflect this risk. The difference in the discount rate on a corporate bond compared to a government bond is called the credit spread. Put simply, the higher the risk of the issuer defaulting, the higher the credit spread.
For corporate bonds, it could be said that the term fixed income is a little misleading as, even though the size and timing of cash flows are known at the outset, the cash flows will only happen if the issuer is still around to pay them.
As the discount rate changes, either because of a change in the risk-free interest rate or the credit spread, so does the value of the fixed income instrument.
Examples of Fixed Income Instruments
So far, we have mentioned government bonds and corporate bonds as typical instruments. Within the corporate bond category, the distinction between “investment grade” and “high yield”, or “sub-investment grade”, is common. Investment grade refers to issuers with a S&P credit rating of BBB- or better, while high yield bonds have lower ratings which reflect a greater risk of default.
Other common fixed income instruments include municipal bonds (issued by a municipality or some other form of local government) and agency bonds (which are issued by entities backed by a government entity).
Simple Pricing Example
Below you can see a simple example of two fixed income instruments (bonds). Both have a face value (principal) of 1000.0, coupon rates of 5.0% per annum and 10 years to maturity. All cash flows are known and pre-defined. However, as the discount rate is significantly higher for the corporate issuer, the price of the bonds is significantly different, with the government bond being more valuable due to the lower associated risk.
