Fixed income is an asset class made up of various debt instruments, mainly bonds, which are obligations and function similarly to an IOU.

The issuers of debt instruments are typically governments or corporations. 

The purchasers of these instruments include many kinds of investors, such as large institutions like retirement funds, investment management companies, hedge funds, banks, companies, and governments as well as individual investors.

These obligations commit borrowers to pay back the sum they borrowed typically plus a regular fixed amount of interest.

The amount repayable, the interest due, if any, and the dates when these are supposed to be paid are stated in the offering materials for the instrument.

In many cases, debt instruments trade on exchanges, like equities.

The issuer only receives money when they initially sell these securities, not when investors subsequently buy and sell them to each other on the secondary market. 

As we’ll see, investors buy these securities for various motives, including the potential to: 

• Preserve wealth

• Seek capital gains 

• Earn income 

• Diversify risks from other investments 

• Sell quickly if they need cash

Fixed income comes in many shapes and sizes, though, and can offer a range of different potential benefits and risks.

Let’s take a simplified example of how a fixed income security works.

A company borrows money by issuing bonds.

Each bond has a face value of $1000.

The bond promises to pay an annual interest payment – or “coupon” – of 5% of the face value, i.e., $50 a year.

In three years, the bond is due to be repaid, such that the owner will receive the $1000 face value, provided that the issuer does not default on the bond. 

In the meantime its price on the secondary market can move around.

If market interest rates go up, the bond’s price will typically fall, and if they go down, the bond’s price will typically rise. If a borrower’s financial health is seen to get better or worse, its bond price may also rise or fall respectively.

The yield or interest rate on bonds will vary according to numerous factors. Generally, speaking borrowing money for longer requires a higher yield to be paid. Likewise, companies or governments with worse credit ratings usually have to pay higher yields. 

Most companies and governments need to borrow money at least some of the time.

Companies typically borrow money to pay their bills day-to-day as well as for major new projects or buying other companies.

Governments borrow money when they need to spend more than they receive from their citizens in taxes.

They may spend it on running their countries day-to-day, for building vital infrastructure or to finance municipal or governmental projects. 

But why issue fixed income securities rather than, say, borrowing from banks?

One reason is that it’s usually possible to borrow larger sums via fixed income markets than from individual lenders.

The fixed income markets may also enable borrowing for longer periods. Some companies or governments have issued bonds repayable in thirty, fifty or even a hundred years.

Some fixed income securities are sold with a fixed interest rate, so the borrower know how much will have to be paid in interest. 

Bank loans, by contrast, usually have variable interest rates.

Alongside equities, fixed income is one of the main ingredients in most investment portfolios.

Indeed, one of the simplest and most widely followed asset allocations is a portfolio made up of 60% equities and 40% fixed income.

The equity component of such a portfolio seeks to grow the investor’s capital over time. 

The fixed income part of the portfolio seeks to preserve the investor’s capital and provide some income.

Crucially, fixed income and equities may do well and badly at different times.

High quality bonds – aka “investment grade” – such as those of the most financially secure governments and companies – may potentially help stabilize portfolios at difficult moments.

On many occasions when the stock market has fallen hard, high quality bond prices tend to rise, as investors seek perceived safety.

In the Great Depression of the early 1930s, for example, and during the Global Financial Crisis, US Treasuries gained in value even as equities plunged.

For investors owning both asset classes, gains on high quality fixed income can mitigate some of the losses on equities.

However, there are no guarantees here. 

A few times, equities and fixed income have both fallen over the same one-year period, such as in 2022. 

Lower quality bonds – whose less financially secure issuers pay higher yields to compensate investors for their riskiness – tend to behave differently to high quality bonds.

While they can perform better during times of optimism and economic growth, they may struggle more amid uncertainty, and have higher risk of defaulting on their obligations.  

More cautious investors will tend to keep a higher proportion of their assets in high quality bonds versus other asset classes than more risk-seeking investors.

Interest rates can impact bonds both when they increase and decrease. 

Generally, when interest rates go up, bond prices go down. The pain is magnified for bonds that are due for repayment far into the future. 

When interest rates fall, certain bonds allow their issuers to repay investors early.

Having repaid investors, those borrowers can issue new bonds at lower interest rates.

Investors therefore face reinvesting their money at a lower rate than when they initially invested.

Inflation is another major risk for bonds, as it eats away at the real value of both interest payable and the principal. 

While fixed income securities represent a legal obligation on the borrower to repay, this is not guaranteed.

The yield on bonds from the most financially secure governments is sometimes called the “risk-free rate.”

But while that reflects a belief that those governments will repay their investors one way or another, don’t be deceived: fixed income securities of all varieties come with varying degrees of risk.

Companies can end up defaulting, meaning the holders of their debt instruments end up missing on some or all of what they’ve invested plus interest due. 

This is especially true with the issuers of “high yield” debt, sometime called “junk bonds.”

The same goes for governments. Some developing economies have defaulted on their sovereign debt multiple times over history.

Then there’s liquidity, the ease (or difficulty) with which fixed income securities can be bought and sold.  Although high quality debt instruments from major issuers such as the US government are generally liquid, this is certainly not true of all fixed instrument securities, particularly in times of market stress.