Fixed Income Explanation, Types, and Impact on Economy
Why People Buy Fixed Income Invesments
Fixed income is an investment that returns a payment to you on a regular schedule. The most common are pensions, bonds, and loans. Fixed income also includes certificates of deposit, savings accounts, money market funds, and fixed-rate annuities. You can also invest in fixed income securities with bond mutual funds, exchange-traded funds, and fixed income derivatives.
Types of Fixed Income
There are four broad categories of fixed income investments. Short-term products return a low rate, but you only tie up your money for a few months at most. Long-term products pay a higher rate, but you must leave your money invested for years.
The interest rates on short-term fixed-income accounts are based on the fed funds rate, or equivalent Treasury bill rates of four years or less. When the fed funds rate was lowered to zero in 2008, these products earned super-low interest rates. To gain a higher yield, individual investors shifted from short-term to longer-term investments. Businesses use short-term loans to cover the cash flow needed to pay for day-to-day operations.
- Savings Accounts: The bank pays you a fixed rate of interest, based on the fed funds rate. You can add or withdraw whenever you like.
- Money Market Accounts: The bank pays you a slightly higher fixed rate of interest. In return, you must keep a minimum amount deposited. You are limited in the number of transactions you can make in a year.
- Certificates of Deposit: You must keep your money invested for an agreed-upon period to get the promised rate of return.
- Money Market Funds: These are mutual funds that invest in a variety of short-term investments. You get paid a fixed rate based on short-term securities. These included Treasury bills, federal agency notes, and Eurodollar deposits. They also included repurchase agreements, certificates of deposit, and corporate commercial paper. They are also based on obligations of states, cities, or other types of municipal agencies.
- Short-term Bond Funds: These mutual funds invest in one-year to four-year low-risk bonds. Most of their holdings are corporate bonds.
Long-term fixed-income investments are called bonds. They are how organizations get substantial loans. Unlike loans, bonds can be bought or sold like any security. The interest rates on these accounts follow Treasury notes and bonds. The rate depends on the duration of the bond.
Bond prices go down when stock prices go up. Bonds are lower return and lower risk than stocks. Investors buy them when they want to avoid risk.
Here are the different types of bonds.
- Government bonds are the safest because they are guaranteed. Since they're the safest, they offer the lowest return. U.S. Treasury notes and bonds are the most popular, with $16.6 trillion outstanding in 2019. Savings bonds are also guaranteed by the U.S. Treasury. They are designed for smaller investors. Municipal bonds, at $3.8 trillion outstanding, are sold by cities.
- Corporate bonds offer a higher rate. Companies sell them when they need cash but don't want to issue stocks. There are currently $8.1 trillion in these bonds outstanding.
- There are two hybrids of corporate bonds and stocks. Preferred stocks pay a regular dividend, even though they are a type of stock. Convertible bonds are bonds that can be converted to stocks. Stocks that pay regular dividends are often substituted for fixed-income bonds. Although they are not technically fixed income, portfolio managers often treat them as such.
- Eurobonds is the common name for Eurodollar bonds. They are corporate bonds issued in euros instead of their own country's currency or U.S. dollars.
- Bond mutual funds are mutual funds that own a large number of bonds. That allows the individual investor to gain the benefits of owning bonds without the hassle of buying and selling them. Mutual funds grant greater diversification than most investors could obtain on their own.
- Exchange-traded funds (ETFs) track the performance of a bond index. They aren't actively managed like a mutual fund. Bond ETFs are popular because they have low costs.
Fixed Income Derivatives
There are many financial derivatives that base their value on fixed income products. They have the most potential return because you invest less of your money. But if they lose money, you could lose much more than your initial investment. Sophisticated investors, companies, and financial firms use them to hedge against losses.
- Options give a buyer the right, but not the obligation, to trade a bond at a certain price on an agreed-upon future date. The right to buy a bond is called a call option. The right to sell a bond is the put option. They are traded on a regulated exchange.
- Futures contracts are like options, except they bind participants to execute the trade. They are traded on an exchange.
- Forward contracts are like futures contracts, except they are not traded on an exchange. Instead, they are traded Over the Counter, either between the two parties directly or through a bank. They are often very customized to the particular needs of the two parties.
- Mortgage-backed securities derive their value from bundles of home loans. Like a bond, they offer a rate of return based on the value of the underlying assets.
- Collateralized debt obligations base their value on auto loans and credit card debt. Sometimes they use bundles of corporate bonds for their value.
- Asset-backed commercial paper are one-year corporate bond packages. They are based on underlying commercial assets. These include real estate, corporate auto fleets, or other business property.
- Interest rate swaps are contracts that allow bondholders to swap their future interest rate payments. These are between a holder of a fixed-interest bond and one holding a flexible-interest bond. They trade Over The Counter. Swaptions are options on an underlying interest rate swap. They are a derivative based on a derivative. They should only be used to speculate about interest rate movements.
- Total return swaps are like interest rate swaps, except the payments are based on bonds. They can also derive their value from a bond index, an equity index, or a bundle of loans.
Third-Party Fixed Income Payment Streams
Some fixed income streams don't depend on the value of an investment. Instead, the payment is guaranteed by a third party.
Fixed payments available after a certain age. It's guaranteed by the federal government and is calculated based on payroll taxes you've paid. It's managed by the Social Security Trust Fund.
Fixed payments guaranteed by your employer, based on the number of years you worked and your salary. Companies, unions, and governments use pension funds to make sure there's enough to make the payments. As more workers retire, fewer companies are offering this benefit.
Fixed-rate annuities are an insurance product that guarantees you a fixed payment over an agreed-upon period. These are increasing since fewer workers receive pensions. One variation of this product that can provide some long-term upside is a variable annuity. In certain cases, it can offer an agreed-upon fixed payout stream, which is underwritten based on a basket of equities funded with your initial contribution. The basket of equities can increase the value of the annuity in the event of a major increase in the equity market, but still provide a base level fixed income.
How Fixed Income Affects the U.S. Economy
Fixed income provides most of the liquidity that keeps the U.S. economy humming. Businesses go to the bond market to raise funds to grow. They use money market instruments to get the cash needed for day-to-day operations.
Treasury bills, notes, and bonds help set interest rates. How? When demand for Treasury bonds falls, yields rise. Investors then demand higher interest rates on similar fixed-income investments. That send rates higher on auto, school, and home loans.
Low-interest rates might trigger inflation. That's because there's too much liquidity chasing too few goods. If inflation doesn't show up in consumer spending, it might create asset bubbles in investments.
You can also use Treasury yields to predict the future. For example, an inverted yield curve usually heralds a recession. When that happens, it has the same effect on mortgage interest rates. It affects the demand for real estate, which supports 6 percent of the economy. Bonds affect mortgage interest rates because they are competing with the same investors. When bond rates fall, then mortgage rates must too.
The Value of a Dollar
The demand for Treasury notes is one also of the three factors that affect the value of the dollar. That's because both are seen as safe-haven investments, and tend to rise and fall together. But sometimes the expectation of high-interest rates will drive up demand for the dollar.
Demand for fixed income investments skyrocketed after the 2008 recession. That's because the Federal Reserve's expansionary monetary policy kept interest rates at a record low for seven long years. Risk-averse investors shifted more of their portfolios to fixed income products. They needed to maintain payments at the same level.