Fixed income

Fixed income includes financial instruments issued by governments or companies to raise funds. These instruments work as loans that investors provide in exchange for periodic interest payments (the "coupon") and the return of the principal at maturity.

 

Types of Bonds and Obligations

Government Bonds and Obligations (>2 years)

These are instruments issued by the government to finance long-term projects. Bonds usually have a maturity period of more than two years, and obligations can extend to 10 or 30 years. They are considered safe investments as they are backed by the government.

 

Treasury Bills (<2 years)

Treasury bills are short-term instruments with maturities of less than two years. They offer lower returns compared to bonds but come with lower risk.

 

Zero-Coupon Bonds

These bonds do not pay periodic interest. Instead, they are issued at a price lower than their face value, and the investor receives the full value at maturity. For example, you might purchase a bond for $800 and receive $1,000 upon maturity.

 

Inflation-Linked Bonds

These bonds are designed to protect investors against inflation. The principal and interest are adjusted based on the Consumer Price Index (CPI) or another inflation indicator.

 

Junk Bonds

These are bonds issued by companies with low credit ratings. Ratings are typically assigned by agencies such as Standard & Poor's, Moody's, and Fitch Ratings. These agencies use scales to evaluate credit risk, where ratings like 'BBB' or higher are considered "investment grade," while ratings like 'BB+' or lower are categorized as "junk bonds." Although they offer high returns, they come with a higher risk of default.

 

Corporate Debt

This type of bond is issued by companies to finance their operations or projects. Corporate bonds can be:

• High Credit Quality: Issued by solid and stable companies.
• Low Grade (Junk Bonds): Issued by riskier companies but with higher potential returns.

 

Money Market Funds

Money market funds are collective investments that focus on very short-term fixed income assets. A notable example is the Fidelity Money Market Fund, known for its stability and ease of access, used by investors to maintain liquidity. Another example is the Vanguard Federal Money Market Fund, which primarily invests in securities backed by the U.S. government. These are highly liquid and safe instruments, often used to preserve capital and generate small returns.

 

How Do Interest Rate Changes Affect Bonds?

Changes in interest rates have a direct impact on the value of bonds:

• When interest rates rise: The price of existing bonds tends to fall. This happens because new bonds offer a higher coupon, making them more attractive compared to older bonds.
• When interest rates fall: The price of existing bonds rises since their coupon is more attractive compared to newly issued bonds with lower coupons.

 

The sensitivity of a bond to changes in interest rates is measured through a concept called duration. Duration is a measure that estimates how much a bond's price will change in response to variations in interest rates, expressed in years. Bonds with a higher duration are more sensitive to interest rate fluctuations, meaning small changes in rates can lead to significant price variations.

Additionally, the term sensitivity is used to measure the direct impact on a bond's price for every percentage point change in interest rates. Duration and sensitivity are key tools for evaluating the risk associated with bond investments.