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Finance Talk: Understanding Fixed Income

Posted on June 7, 2016 10:00 am;

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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!

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