Fixed-income trading is the process of trading fixed-income securities over-the-counter (OTC). The fixed-income market offers low transaction costs, a competitive market structure, and a large, diverse collection of market participants. The fixed-income securities market is dominated by institutional investors.
What is a Fixed-Income Security?
A fixed-income security, or debt security, is a claim on a particular periodic income stream from interest paid on borrowed funds. Fixed-income securities are named so because they guarantee a stream of income that is determined by a fixed formula.
There are several different types of financial instruments that make up the fixed-income market, but the most commonly traded are government or corporate bonds.
Factors Affecting Fixed-Income Trading
The following factors affect fixed-income trading:
Credit/default risk refers to the likelihood that the issuer of a security may be unable to:
Pay interest and/or principal in a timely fashion
Comply with the provisions of a bond indenture
The probability of credit/default risk depends on the issuer’s ability to meet their financial obligations and on their creditworthiness. There is a negative correlation between credit rating and yield. The lower the issuer’s credit rating, the higher the yield (to compensate for higher credit risk) and vice-versa. A change in the issuer’s credit rating affects the value of their outstanding fixed-income securities.
Interest rate risk
There is a negative correlation between the price of debt securities and interest rates. However, there is a positive relationship between interest rate and yield. Interest rate risk arises when a change in interest rates has an adverse impact on the yield of debt securities.
Reinvestment rate risk
This refers to the probability of a decline in the interest rate causing a decline in the options available for reinvesting the interest income received at higher or similar rates in the market.
Price risk results when, due to an adverse movement in prices, the investor does not receive the expected price when selling a bond or other debt security in the secondary market. This is particularly relevant for investors who want to access the principal amount before the maturity date of the security, as they have to rely on the prevailing market price of the security, which may be higher or lower than the price they originally paid for the security.
Purchasing power risk
Fixed income investors look at the real rate of return on their investments.
Real Rate of Return = Actual Rate of Return – Rate of Inflation
Inflation reduces the purchasing power of the principal invested and the investment income. Thus, inflation has an inverse relationship with the real rate of return. The higher the inflation rate, the lower the real rate of return (and vice-versa). If the inflation rate is high, there is a possibility that an investor’s real rate of return on their fixed-income investments may be negative. For example, if a bondholder is receiving 3% interest payments on a purchased bond, but the inflation rate is 5%, then the bond holder’s real rate of return is negative (-) 2%.
Reasons to Invest in Fixed-Income Securities
To achieve different investing goals, an investor can invest in different types of fixed-income securities:
Capital appreciation: Those aiming to make maximum capital gains should primarily invest in low-rated securities like emerging market debt or high-yield bonds. If interest rates are likely to fall, investing in government bonds and long-term maturity corporate bonds should also result in strong capital gains. Corporate bonds typically offer higher returns than government bonds due to the fact that they carry more risk.
Income: All fixed-income securities (with the exception of zero-coupon bonds) provide some form of regular interest payments to investors. This makes the fixed-income market especially attractive to investors whose main investment goal is providing themselves with a steady income.
Safety:Risk-averse investors seeking primarily the safest investments should invest in securities with short maturity periods (less than 5 years) to reduce interest rate risk, and in securities with a high credit rating – to avoid default risk. Some debt securities that meet both of these criteria are U.S. Treasury bills, money market instruments (especially certificates of deposits), short-term corporate debt, and municipal bonds issued by municipalities with a high credit rating.
Tax advantages: Investors seeking to maximize their after-tax income often favor investing in municipal bonds, as the income received from them is usually tax-free.
There is a wide variety of fixed-income investments and investing strategies available for you to consider. Make sure to thoroughly research any fixed-income opportunity prior to making an investment. Because many bonds have maturity dates of 10 years or more, purchasing a bond means tying up a substantial amount of your investment capital for a long period of time. Therefore, you want to make sure that you’re making the best use of your money with your choice of investments.