Ever wondered why bonds and fixed income investment are used interchangeably in conversation? What’s the point – why not just refer to them as bonds? You’ve probably stumbled across this article to find out exactly WHY bonds are also referred to as fixed-income investments. I won’t keep you waiting any longer… Let’s get into it!
Bonds are also known as Fixed-Income investments because they provide a fixed income in the form of interest, over the term of the bond. An example would be, if a bond is issued with an interest rate of 5%, the bondholder would receive interest income fixed at 5% of the face/par value.
Okay, great – we know why bonds are also called ‘Fixed Income’ investments but are all aspects of bonds really fixed, and are there any exceptions to bonds actually being a source of Fixed Income.
A great place to start would be to first ensure we are on the same page – let’s quickly run through some important vocab just to make sure you don’t get lost as you read on.
Bonds Basics
Let’s start right at the foundations – we’ll make this brief, don’t worry.
- Coupon Rate – fixed rate of interest paid to the bondholder;
- Face/Par Value – the price of a bond that investor must pay to become a bondholder; and
- Maturity – term of the bond.
Just for some context, bonds are essentially a loan from an investor to the issuer. This is a whole other topic but not the point of this article so I won’t get into it for the moment.
Now we’ve been acquainted with this short glossary of terms – let’s take a look at which of these are truly fixed and which are up for debate.
Is The Coupon Rate Fixed?
As we know, the Coupon Rate is the rate of interest that will be paid to the bondholder over the term of the bond.
Right at the start of the article, we gave the example of a bond being issued with an interest rate of 5% – in investor terms, the bond has a coupon rate of 5%. This 5% is based on the face/par value at the time the bond is issued.
In terms of interest payouts, they are typically every 6 months. However, if you’re only looking at investing in bonds for capital growth – you can trade bonds on the share market whenever you like, although you do forego those juicy payouts.
However, there is one special type of bond that doesn’t pay you ANY interest until right at the end of the bond maturity. These are called ‘Zero-coupon’ bonds – again, a topic for another time.
A Word About Face/Par Value
It’s common that bonds are issued at around £100 or $100 depending on where the issuer is based.
A key thing to remember here is that this Face/Par value can actually change. If you paid attention in your Economics class, you’ll know that the stock market determines investment values based on supply and demand.
Higher demand and lower supply will lead to an increase in the value. The flip side is also true – lower demand and higher supply leads to a decrease in value.
Now you may be wondering – ‘if interest is paid at 5% based on the face value and the face value changes based on demand – does my interest change?’ NO.
The beautiful thing here is that you’ll keep receiving 5% interest based on the face/par value AT ISSUE rather than at its current face/par value.
In short – the face/par value is most definitely NOT fixed.
Maturity – To Be, Or Not To Be… Fixed.
Bond maturity is set by the issuer of the bond and can range anywhere between 1 and 30 years!
Now, before you panic that you need to own the bond for the full 30 years – you don’t. Bonds are openly traded on the stock market, which we’ve established is why the face/par value does not remain fixed.
So bonds are given a set maturity date – so this must mean the maturity is fixed… right?
As a general rule, yes. That’s correct. However, there is an exception to this. Enter Callable Bonds.
In short, Callable Bonds just allow the issuer to repay the bond before its maturity. All this means is that the investor is repaid the face value of the bond and all interest payments will stop.
So Who Issues These Bonds
Although not directly relevant to what sorts of elements are fixed in terms of bonds, it’s great to understand who can issue these bonds – just whilst I’ve got your attention.
Typically, bonds can be issued by governments (treasury bonds), corporations (corporate bonds), and municipal bonds (typically for the US, issued by a given state or county).
Government bonds are typically Treasury bonds and are issued in order to fund government projects such as construction. These bonds encourage the average Joe to help fund local projects and receive a tasty interest payment for their troubles. They’re super attractive to investors because they’re government-backed so they’re a relatively safe choice for investment.
Corporate bonds can vary in terms of the type of bonds that are issued but they’re generally used to fund company activities. It saves them from having to take out large loans with unfavourable interest/repayment terms and means they don’t need to issue any shares and dilute shareholder ownership.
Municipal bonds are essentially the same as Government bonds but for specific states.
Summary
To summarise everything we’ve covered on why bonds are called fixed income:
- All bonds have a fixed coupon rate and therefore the income is fixed (technically);
- However, Zero-coupon bonds, although they have a fixed coupon rate, only pay the fixed figure at the end of the bond’s maturity;
- Face/Par value of bonds are not fixed and are dictated by the demand/supply of the given bond on the market; and
- The maturity of bonds is generally fixed, but Callable bonds can be repaid earlier by the issuer.
- Bonds can be issued by a variety of organisations including Governments, Municipalities, and Corporations.