Understanding Fixed Income

What is Fixed Income?

Fixed income describes a variety of debt instruments, although it most commonly refers to bonds
Typically, a borrower such as a government or a company may issue a bond, which is a contract outlining the conditions of a loan, to a bond holder (lender)
This involves an exchange of principal at inception and at maturity, and periodic interest payments, known as coupons, from the issuer to the holder

Does fixed income mean a fixed return?

It is a frequent misconception that the return of a bond is fixed. True, the income component, equal to the bond’s coupons and set when the bond is first issued, is a fixed sum
Likewise, if an investor were to purchase a bond at issue (for the full principal amount, known as par) and hold it to maturity, without the issuer defaulting, then the return would be fixed because the principal would be repaid. The preservation of capital in this instance is one of the attractions of owning bonds
But a bond’s price fluctuates throughout its lifetime and the investor can hope to make capital gains when prices rise
Why do bond prices change? As with any tradable financial asset, prices reflect the balance of buyers and sellers, whose demand can be affected by changes in interest rates or economic sentiment
The expected income return from coupons is known as the running yield
But the most reliable measure for estimating the annual percentage return of a bond held to maturity is yield (short for yield-to-maturity) which takes into account the total return ie coupon payments and any changes in value as the principal reverts to par, coupons and the full principal amount

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