The Fixed Income Market

When people talk about investing, attention is normally given to the stock market. But, the bond market, also called the fixed income market, is just as important. Two of the most common types are government bonds and corporate bonds, and understanding them helps beginners see the balance between safety and risk.

Government and Corporate Bonds

Government bonds are given out by national governments to be used for spending activities, like financing a war. In the US, we call these treasuries. Especially since the US government is considered extremely trustworthy, our bonds are seen as the safest asset money can buy and virtually risk free. Buying a government bond is like lending money to your most responsible relative.

Corporate bonds are issued by companies to raise money for projects or expansion. They usually pay higher interest than government bonds since they carry more risk. With companies, they can easily fail compared to a government.

For any bond, credit ratings help investors judge how safe is it. This applies to both governments and corporations. Lending to a strong company is relatively safe while lending to a weaker company may pay more, but it comes with greater risk. These ratings are different depending on each agency, but we normally consider triple-A to be the best.

Bond Prices and Yields

One of the most important things to understand about the bond market is the relationship between price and yield. The two move in opposite directions: When bond prices go up, yields go down, and vice versa.

To understand why, imagine a bond that pays 50 dollars a year in interest. If the bond costs 1,000 dollars, the yield is 5 percent. But if the price of that bond rises to 1,100 dollars, you are still only getting 50 dollars a year, which means the yield drops to about 4.5 percent. On the other hand, if the bond’s price falls to 900 dollars, that same 50 dollars a year now represents a yield of about 5.6 percent.

Yields are determined by several factors:

• Interest rates set by central banks. When rates rise, new bonds pay more, so older bonds lose value and their yields adjust upward.
• Inflation expectations. Higher inflation erodes the value of fixed payments, so investors demand higher yields.
• Credit risk. Safer issuers like governments can offer lower yields, while riskier companies must offer higher yields to attract buyers.

Another way of thinking about yields is in comparison to the interest rates offered at banks. What a yield tells you is the interest rate at which the amount of money you would get back by putting your money in a bank account over that same period of time would be the same investing in the bond (assuming that each payment out of the bond is put into that account at that same rate).

I know that’s a mouthful at first, but let’s break it down. If I buy a 2 year bond for $980 with a face value of $1,000 that pays 5% interest each year, I’d get $50 in coupon payments annually and $1,000 back at the end of two years. The yield on this bond is about 6.05%. In other words, putting $980 in a bank account earning 6.05% per year would give you the same total return after two years as the bond would, as long as you reinvest the coupon payments at that same rate.

The bond market may not be as flashy as stocks, but it is essential for building a diversified portfolio.

Disclaimer:

This blog post is for educational and informational purposes only. It is not financial advice. I am not a licensed financial advisor, and nothing in this post should be interpreted as a recommendation to buy or sell any securities. Trading involves risk, and results are not guaranteed. Past performance is not indicative of future results. Always do your own research and consult with a licensed financial professional before making any investment decisions.