Fixed income
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Fixed income refers to any type of investment that yields a regular (fixed) payment. For example, if you borrow money and have to pay interest once a month, you have issued a fixed income security. When a company does this, it is called a bond (although 'preferred stock' is also sometimes considered to be fixed income).
The term fixed income is also applied to people's income which are invariant each period. This could include income derived from fixed income investments such as bonds and preferred stocks or pensions that guarantee a fixed income.
Fixed income securities can be contrasted with variable return securities such as stocks. To understand the difference between stocks and bonds, you have to understand a company's motivation. A company wants to raise money, and it doesn't want to wait until it has gotten enough through regular operations (selling products or providing services). In order for a company to grow as a business, it must raise money. Investors will only give money to the company if they believe that they will be given something in return. The company can either pledge a part of itself, by giving equity in the company (stock), or the company can give a promise to pay regular interest and borrow the money (bond).
While a bond is simply a promise to pay interest on borrowed money, there is some important terminology used by the fixed income industry:
- The principal of a bond is the amount that is being lent.
- The coupon is the interest that will be paid.
- The maturity is the end of the bond, the date that the amount must be returned.
- The issuer is the entity (company or govt.) who is borrowing the money (issuing the bond) and paying the interest (the coupon).
- The issue is another term for the bond itself.
- The indenture is the contract that states all of the terms of the bond.
People that invest in fixed income securities are typically looking for a constant and secure return on their investment. For example, a retired person might like to receive a regular dependable payment to live on, but not use up their money. This person can buy a bond with their money, and use the coupon payment (the interest) as that regular dependable payment. When the bond matures, the person will have their money returned to them.
Interest rates change over time. For example, if a company wants to raise $1 million and not a lot of people in the market have free cash to lend, the company will have to offer a high rate of interest (coupon) to get people to buy their bond. If there are a lot of people in the market trying to get a return on their money, the company can offer a lower coupon.
To complicate matters further, fixed income securities are actually traded on the open market, just like stocks. To understand this, first realize that bonds are usually traded in certain amounts, for example $100,000. If you want to receive 7,000 a month and the going interest rate is only 6%, you will have to pay a premium to get the amount you want. Likewise, if you need only 5,000 a month, you can get that bond at a discount.