Finance Talk: Understanding Fixed Income
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by Tom C
Although the media focuses predominantly on the equity market, the fixed income bond market is
actually much larger. The chances are that fixed income bonds will make up a large part of your
investment portfolio so it pays to understand them as much as you understand stocks and shares.
The basic difference is that while buying stocks means buying a piece of a company and its profits, a
bond is a fixed loan. Companies, governments and other organisations will issue bonds as a way of
raising money – but it works in much the same way as a loan. If you buy a bond, you will be the
creditor, and the issuer will be the debtor. They will have to pay your loan with interest.
Buying a bond does not buy you a piece of the company so you do not benefit as the company
prospers. Instead you’ll be paid the agreed return for the duration of the bond. You will also be
protected – to a degree – if a company files for bankruptcy. Bond holders are first in line when it
comes to having a claim on a company’s assets. As such, they are considered less risky – but that
doesn’t always mean returns have to be much poorer.
The value of a bond will depend on the quality of the issuer. Generally speaking, the more stable the
issuer’s business the lower interest they will pay. For example, a high quality bond from a company
with a strong balance sheet will pay a lower interest rate than those with a much less stable financial
position. They need to offer a high interest rate in order to attract business.
At the most risky end of the market you’ll find the so-called junk bonds. They pay high interest, but
with that comes a much greater risk of default. If you’re setting up a portfolio of bonds, it makes
sense to diversify your holdings to spread your risk.
There are many ways to invest in this sector. You can buy bonds directly from some organisations –
for example you could purchase US Treasury Bonds – you could buy them on the open market
through a broker or you could buy a mutual fund. This provides all the diversification you need
within a single holding.
The bond market is indeed much less well understood than equities. Because of this, it pays to tread
carefully. As always, ensure you understand the risks and if possible get a financial advisor to help
with your investments.
Enrolling in a professional qualification such as the CFA will get you up to speed on this topic and
turn you into an expert in no time!