Fixed Income: Definition, Types, and Economic Impact

Why Do People Purchase Fixed-Income Investments?

A fixed-income investment is one that provides a consistent stream of cash flows. Defined-benefit pensions, bonds, and loans are common examples. Fixed income is represented by certificates of deposit, savings accounts, money market funds, and fixed-rate annuities. Fixed-income securities can be purchased through bond mutual funds, exchange-traded funds (ETFs), or fixed-income derivatives.

Fixed Income Varieties

Fixed-income investments are classified into four broad categories. Short-term products pay a low-interest rate but only hold your money for a few months at most. Long-term products pay higher interest rates, but you must leave your money invested for years to reap the benefits.

Short-Term

The federal funds rate influences short-term fixed-income account interest rates. When the federal funds rate was cut to zero in 2008, these products earned extremely low-interest rates. Many individual investors shifted from short-term to long-term investments in order to increase their yield. Short-term loans are used by businesses to cover the cash flow needed to pay for day-to-day operations. Savings accounts: The bank will pay you a fixed interest rate based on the fed funds rate. You can add or remove money whenever you want. Money market accounts pay a slightly higher fixed interest rate. In exchange, you must keep a certain amount of money deposited. You are restricted to a certain number of transactions per year. Certificates of deposit: To receive the promised rate of return, you must keep your money invested for an agreed-upon period. Money market funds are mutual funds that invest in a wide range of short-term investments. You are paid a fixed rate based on short-term investments. Treasury bills, federal agency notes, and Eurodollar deposits are examples of these. Repurchase agreements, certificates of deposit, and corporate commercial paper are also examples. They are based on state, city, or other types of municipal agency obligations. Short-term bond funds invest in one- to four-year bonds, primarily investment-grade corporate bonds.

Long-Term

This instrument represents a debt agreement between a corporate or government issuer and an investor (the creditor). The interest rates offered on corporate issues are determined by Treasury rates as well as the credit risk and duration risk associated with the issue. Investment-grade bonds are generally thought to be safe investments. As a result, they typically provide lower returns than higher-risk assets like stocks. Bond prices have historically had little correlation with stock prices and even a negative correlation during recessions. However, in recent years, the two asset classes have demonstrated a much higher degree of correlation.

The following are the various types of bonds:

Because they are guaranteed, government bonds are the most secure. They have the lowest returns because they are the safest. With $16.6 trillion in outstanding in 2019, US Treasury notes and bonds are the most popular. The US Treasury also guarantees savings bonds. They are intended for small-scale investors. Municipal bonds, with a total outstanding value of $3.8 trillion, are issued by cities, states, and other municipalities. Corporate bonds have a higher interest rate. When a company needs cash but does not want to issue stock, they sell them. There is currently $8.1 trillion in outstanding bonds. There are two types of corporate bond-stock hybrids. Despite being a type of stock, preferred stocks pay a regular dividend. Bonds that can be converted to stocks are known as convertible bonds. Dividend-paying stocks are frequently used in place of fixed-income bonds. Even though they are not technically fixed-income securities, portfolio managers frequently treat them as such. Eurobonds are a popular term for Eurodollar bonds. International bonds are denominated in a currency other than the domestic currency of the market in which they are issued. For example, a European company issuing bonds in Japan denominated in US dollars. Bond mutual funds are mutual funds that invest primarily in bonds. It enables the individual investor to reap the benefits of owning bonds without having to deal with the hassle of buying and selling them. Mutual funds provide more diversification than most investors could achieve on their own. ETFs are securities that track the performance of a bond index. They are not actively managed in the same way that mutual funds are. Bond ETFs are popular due to their low costs.

Derivatives of Fixed Income

Many financial derivatives derive their value from fixed-income products. They have the highest potential return because you invest the least amount of money. However, you may lose a lot more than your initial investment if they lose money. Sophisticated investors, companies use them, and financial firms hedge against losses. Options grant a buyer the right, but not the obligation, to trade a bond at a predetermined price on a future date. A call option is the right to purchase a bond. The put option is the right to sell a bond. They are exchange-traded on a regulated platform. Futures contracts are similar to options in that they bind participants to carry out the trade. They are traded on the market. Forward contracts are similar to futures contracts, except that they are not traded on an exchange. They are instead traded over the counter (OTC), either directly between two parties or through a bank. They are frequently highly tailored to the specific requirements of the two parties. The value of mortgage-backed securities (MBS) is derived from bundles of home loans. They, like bonds, provide a rate of return based on Treasury rates as well as the risks associated with the underlying assets. The value of collateralized debt obligations (CDOs) is derived from various underlying assets, such as corporate bank loans, auto loans, and credit card debt. Asset-backed commercial paper is a one-year package of corporate bonds. They are founded on commercial assets. Real estate, corporate auto fleets, and other commercial property are examples. Contracts that allow investors to swap future interest rate payments are known as interest rate swaps (or receipts). This arrangement frequently involves a payer (or receiver) of a fixed-rate stream of interest bond and a payer (or receiver) of a floating-rate stream of interest bond. They trade over the counter. Swaptions are possibilities on an underlying interest rate swap—basically, a derivative on top of a derivative. In general, sophisticated investors should use swaps and swaptions for hedging purposes; inexperienced investors should not use them to speculate on interest rate movements. Total return swaps are similar to interest rate swaps in that they involve the exchange of cash flows related to one asset and another that is linked to a benchmark or index (such as the S&P 500).

Payment Streams from Third-Party Fixed Income

Some fixed income streams are not affected by an investment's value. Instead, a third party guarantees the payment.

Social Security benefits

After a certain age, fixed payments are available. It is federally guaranteed and calculated based on the payroll taxes you have paid. The Social Security Trust Fund is in charge of it.

Pensions

Your employer will make you fixed payments based on how many years you worked and how much you earned. Companies, unions, and governments use pension funds to ensure that payments are made. As more employees retire, fewer companies provide this benefit.

Annuities with Fixed Rates

Fixed-rate annuities are insurance products that guarantee a fixed payment over a set period. These are on the rise as fewer workers receive pensions. A variable annuity is one product variation that can provide some long-term upside. In some cases, it may provide an agreed-upon fixed payout stream based on a basket of equities funded with your initial contribution. In the event of a significant increase in the equity market, the basket of equities can increase the value of the annuity while still providing a base-level fixed income.

How Fixed Income Affects the Economy in the United States

Fixed income accounts for most of the liquidity that keeps the US economy running. Businesses use bond markets to raise funds for expansion (for short-term needs, they use the money markets, which are also comprised of near-term fixed-income securities). They use money market instruments to obtain the funds required for day-to-day operations. Treasury bills, notes, and bonds are used as reference points for other interest rates. Yields rise when demand for Treasury debt falls. As a result, investors demand higher interest rates on other fixed-income products. This raises interest rates on everything from auto loans to student loans to home mortgages.

Inflation

Low-interest rates may cause inflation. It is due to too much liquidity chasing too few goods. If inflation does not affect consumer spending, it may cause asset bubbles in investments. Treasury yields can, in some cases, be used to forecast future economic conditions. For example, an inverted yield curve (short-term rates higher than long-term rates) frequently precedes a recession, resulting in rapidly declining short-term rates (Fed induced) and persistently low long-term rates—until the economy recovers and signs of inflation emerge. When interest rates are reduced, other interest rates in the economy, such as mortgage interest rates, fall as well. This, in turn, impacts the demand for real estate. Thus, changes in interest rates can have an impact on consumer prices.

The Cost of a Dollar

The demand for Treasury debt is a significant factor influencing the dollar's value. This is due to the fact that Treasury debt is denominated in US dollars. In addition, as a safe-haven investment, it is sought after by risk-averse investors both domestically and internationally, particularly during volatile times. It was evident in the aftermath of the 2008 recession, when the Federal Reserve's expansionary monetary policy, which included unprecedented levels of quantitative easing, resulted in an increase in demand for Treasuries and other high-quality debt instruments.