Understanding fixed income

For example, Trevor Welsh, head of UK sovereign and inflation at Aviva Investors, says the borrower may agree to pay its creditors a fixed amount of interest once a year or monthly, and to repay the principal the original amount it borrowed on maturity.

The specific and mandatory nature of the regular income payments are the key difference between fixed income securities and equities, which set dividend levels - if a dividend is even being paid - annually based on company performance.

In essence, Mr Welsh says by purchasing fixed income, you are buying the debt of the company. In contrast by purchasing shares you are buying ownership of a company.

For investors, typically bonds and other fixed income assets are accessed via a fund, which pools and subsequently trades investments and can be assessed in much the same way as any other fund investing in, say, equities.

Generally, Mr Welsh says the majority of managers invest in a range of bonds each paying regular coupons according to a fixed payment schedule. By investing in a diverse range of securities, the manager attempts to minimise the impact on the portfolio of any issuer defaulting.

Generally Karthica Underwood, Chartered Financial Planner at Principal Financial Planning, says fixed income investments generate a known and regular level of income for a fixed period of time.

Ms Underwood says there are some deviations from this, for instance there are some fixed income instruments that do not have a maturity date and also ones where the income or interest rate is not fixed.

Typically she says fixed income investments are in the form of gilts and corporate bonds. Both of these investments are types of debt, issued in the former case by governments and in the latter by companies.

Ms Underwood says: “Fund managers will invest in a range of fixed income instruments. The type of fund will determine the type of fixed income investment they will buy and sell within the fund.

“For example, a high yield corporate bond fund will predominantly hold a range of higher yielding corporate [bonds].

“Fund managers will have an in-house research process with the aim of identifying those holdings that are likely to generate the best returns for the fund based on the fund’s objectives. Fixed income holdings will be bought and sold within the fund as a result of this research. Some holdings may also be held to maturity.”

A key aspect of how managers attempt to optimise performance is related to secondary sales of bonds, which are in issuance for extended periods over many years. As the coupon is set at the outset and does not change, increases in the purchase price of a bond on the secondary market reduce the yield and vice versa.

In short: the yield moves inverse to the price.

In practice this means when a particular type of instrument, for example in recent years government bonds issued by the UK or US, are in demand, the yield deteriorates and those buying in will struggle to generate strong performance.

The flip side of this is that when an area is out of favour, such as eurozone government prior to this year, the coupon on newly-issued debt can be very high to compensate investors for the additional risk related to the debt and secondary prices can be low. This increases the potential yield, but this is at the expense of higher risk and volatility.

Mr Welsh says: “Many managers have their performance measure against a benchmark with an aim of trying to attempt to outperform it.

“For example, the manager of a gilt fund may be mandated to outperform the FTSE Actuaries UK Gilt total return index by a given margin each year. This index incorporates each large and easily traded conventional government bond, weighted according to its relative size.

“The manager tries to achieve this goal by investing in those securities which he or she believes will deliver the strongest risk-adjusted return, and avoid those expected to perform worst.”