Nuts and Bolts: Fixed Income Part 1
Welcome to our new series ‘Nuts and Bolts’ which is designed to explain the inner workings, the cogs, if you like, of the markets and asset classes we all know about but might not fully understand the underlying mechanics of.
‘Nuts and Bolts’ will look to drill right down to the base principles of an asset, the inner workings of the instruments that assets use and how these all fit together to become the markets we invest in.
To start, we are going to tackle one of the biggest asset classes - fixed income. This will go over many parts as fixed income’s nuts and bolts are vast.
To start, let’s define fixed income.
Fixed Income – What is it? What’s it for?
Normally, fixed income is defined as:
An investment in which the borrower or issuer (i.e., a sovereign government) is obligated to make scheduled fixed payments (known as coupon payments) for a fixed amount of time (for example: over a 10-year period).
At maturity (the end of the fixed time) investors are paid the principal amount they invested, in addition to the interest they have received over the life of the investment.
The most common type of fixed income is government and corporate bonds. But why do these entities issue such an instrument?
Let’s discuss government fixed income.
All governments need to fund their expenditure and recurrent operations; think of all the public services needed to run a country, state or local government: health systems, policing, defence, fire, public transport (infrastructure), social security, waste management etc. etc.
To manage the financial position these services place on governments, they need to manage their cash flow, just like any business would by making sure it can finance its expenditure. Hence, in times when it might experience a shortfall in the capital required to cover the expenditure of its service, it might need to issue debt instruments (bonds) to manage its cash flows.
There is an array of fixed income instruments, however, the most common are the following:
- Treasury notes (T-notes) come in maturities between two and 10 years for those in the US, in Australia, T-notes can be as short dated as six months. They are sold in multiples, also known as ‘Face Value’, of $100 per instrument (sometimes referred to as per paper). They pay a fixed interest rate with coupons payments every six-month basis until maturity. At maturity, investors are repaid the principal of the face value.
(This is important, we will dive into this further in a later episode because an investor can buy a bond that is worth more than its face value in the secondary market. If that investor was to hold it until maturity, they would only get $100 per instrument, not the price at which they bought it.)
- The Treasury bonds (T-bonds) are just long-dated T-notes. Every country is different with its longer-dated T-bond maturities and they can be 15-, 20-, 30-, even as long as 100-years. In Australia and the US, Treasury bonds can be purchased in multiples of $100 per paper.
- Treasury Inflation-Protected Securities known as ‘TIPS’. These bond instruments protect the investor from inflation. These bonds are different from other bonds in that the investor’s principal adjusts with inflation and deflation.
- A semi-government or municipal bond as they are called in the US are bonds issued by state, municipality, local or county governments. They work essentially the same as Federal treasuries.
- Junk bonds or high-yield (HY) bonds are sovereign issuers that pay a greater coupon rate due to the higher risk of default. Default is when a federal government fails to pay back the principal and interest on a bond or debt security.
Examples of countries that have or have had junk bond status include:
- Greece during the 2011-12 Euro-crisis when it nearly defaulted on its debt and had junk status for many years after its 10-year bond at one stage had an interest rate of over 25%.
- Argentina which has defaulted (failed to pay interest coupons and or principal) several times over the past three decades. The last default was in the last five years and currently holds junk status.
- As a rule of thumb, emerging and second-world nations tend to hold junk status – i.e., Hungary, Czech Republic, South Africa etc. as their economies are not as creditworthy as developed economies.
- Corporate bonds come in similar designs to their sovereign peers. The price and coupon interest rate offered largely depends on the company’s financial stability and its creditworthiness just like sovereign bonds. Corporate bonds with higher credit ratings typically pay lower coupon rates and just like sovereign bonds, some are classified as junk bonds as the risk of default is higher than a Tier-1 peer. We will discuss corporate bonds in another episode.
All of these instruments are used to manage the cash flow needs of a respective government.
For more information on the types of bonds on offer in Australia, visit the RBA’s website www.rba.gov.au and you can also view how Australia’s bond market is managed through the Australian Office of Financial Management (AOFM) www.aofm.gov.au, a division of the RBA.
For more information about InvestSMART’s investments in the fixed income market visit: https://www.investsmart.com.au/invest-with-us/investsmart-interest-income-model/10