How does it work?
Fixed Income investors provide corporations or government entities with (debt) capital for a pre-defined period against interest payment. Unlike equity investors, they don't own the entity they finance but are creditors. This also means they generally don't have a say in the management of the business. Still, contracts between companies or government entities and Fixed Income investors usually contain covenants that protect the investors against specific actions detrimental to their interest, such as excessive risk-taking.
Fixed Income is a vast, highly diverse asset class. It includes a range of instruments such as coupon bonds, zero-coupon bonds, or convertibles. While the concept of lending money to an entity is straightforward, the actual arrangements between borrowers and investors can vary a lot. Typical factors that need to be defined are the legal entity borrowing the funds, the currency in which money is borrowed and repaid. In addition, the seniority of claims in the case of bankruptcy, the timing and mode of repayment, the timing and size of interest payments (for instance, through regular coupons or at maturity) also play an important role.
These factors significantly impact the risk of a Fixed Income investment and its behavior in different economic and market environments.
How do Fixed Income investments make money?
In its simplest form, a Fixed Income investment is held until maturity, and the investor makes a gain on the difference between the capital committed and the sum of coupons and repayments (principal) received over the lifetime of the investment.
In practice, there are many strategies with varying degrees of sophistication around this. For example, some investors try to benefit most from appreciation in the price of Fixed Income instruments. The price of a Fixed Income instrument depends on the present value of future coupons and repayments, and the present value is a function of the interest rate used to discount these future cash flows. This results in a reverse relationship between this interest rate and bond prices. Suppose the interest rate used to discount the cashflows drops. In that case, the price can increase significantly in the short term. A change in the discount rate can, for instance, be caused by the Central Bank changing interest rates or by a reassessment of the likelihood of a bankruptcy (credit risk).
How risky is this asset class?
It depends. There is no other way to express it. Some Fixed Income instruments such as the bonds issued by government entities of developed nations such as Switzerland or Germany are considered virtually risk-free. On the contrary, the Fixed Income instruments issued by highly indebted corporations often behave almost like stocks. The likelihood of ever getting repaid depends a lot on the development of the company's underlying business. A rule of thumb is that the risk of the investment increases with its lifetime and the likelihood of a default of the issuer.
To assess this likelihood, investors often use credit ratings provided by companies such as Moody's, Fitch, or S&P. These agencies evaluate the creditworthiness of Fixed Income securities, baskets of securities, and their issuers and publish a rating reflecting the default risk associated with it.
For instance, in the case of S&P, the ratings reach from AAA for the highest quality to D for issuances or issuers already in default. Investments with a AAA, AA, A or BBB rating are referred to as investment grade, while investments reaching from BBB to D are speculative.
Why is it important for my portfolio?
Fixed Income investments can provide predictable cash flows, particularly important for investors who regularly need to make payments out of the portfolio.
Investments in low-risk government and corporate bonds are also preferred to store capital in the short-term and generate at least some income.
Historically, there has been a negative correlation between save government debt and risky asset classes such as equity. This can benefit investors greatly during a crisis as gains from the Fixed Income investments offset some of the losses suffered on the equity side.
How do you approach Fixed Income investing?
Managing Fixed Income portfolios is administratively complex as bonds mature and funds need to be reinvested on an ongoing basis. This is why for our clients and us, we generally see little value in picking single bonds. Instead, we rely on the vast universe of cost-efficient Fixed Income funds and ETFs out of which we handpick the best-suited products. In this context, secure government bonds and a well-diversified portfolio of high-quality corporate bonds form the core of our Fixed Income portfolios.
Those instruments are like green vegetables – the safest thing to eat, but it takes more to become an athlete. Apart from combining this core with exposure to equities, we also seek higher returns by selectively taking positions in slightly more risky Fixed Income instruments (High Yield) or specialty investments such as inflation-linked bonds.
The management of foreign exchange rate risk is essential when investing in Fixed Income instruments. While bonds issued by foreign agencies may be virtually risk-free, they may still decline in value in the investor's home currency if the denomination currency depreciates.
For this reason, we always carefully manage the foreign currency exposure associated with such investments, for instance, through hedging through derivatives. However, as hedging is not for free, we tend to overweight Fixed Income instruments denominated in the investor's home currency.
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