Any investment where the borrower or issuer is required to make payments of a fixed amount on a fixed schedule is referred to as having a fixed income. For instance, if the borrower is required to pay interest at a fixed rate once a year, he is also required to repay the principal amount upon maturity.
Equity securities, often known as stocks and shares, can be compared with fixed-income securities because they do not impose any obligations to provide dividends or other forms of income. A firm frequently has to acquire capital to fund acquisitions, purchase machinery or real estate, or invest in the creation of new products in order to expand its business.
The company’s risk profile will determine the terms under which investors will finance the business. The business may give up equity by issuing shares or by guaranteeing repayment of the loan’s principal and interest (bond, bank loan or preferred stock).
The word “fixed” in the phrase “fixed income” refers to both the amount and the schedule of required payments. It is possible to separate “fixed income securities” from notes with variable interest rates, inflation-indexed bonds, and other such features. If an issuer defaults on a fixed income security by missing a payment, the payees may be able to push the issuer into bankruptcy, depending on the applicable law and the security’s form.
A person’s income that doesn’t change much over time is also referred to as having a constant income. This can include earnings from investments that provide a fixed income, such as bonds, preferred stocks, and pensions. The term “fixed income” can also imply that retirees or pensioners have relatively little discretionary income or little financial freedom to make significant or discretionary purchases. This is especially true when pensioners or retirees depend heavily on their pension as their primary source of income.
How do bonds work?
Bonds are by definition debt liabilities issued by governmental or corporate bodies. When you purchase a bond, you are lending the issuer money in return for a fixed amount of interest payments made over a predetermined time frame. When that time period is up, the bond reaches its maturity date and you receive a full refund of your initial investment.
Watching a chess game can be more exciting than tracking bonds, but some investors can get just as giddy watching equities during the Super Bowl. But don’t be fooled by the hoopla (or lack thereof). Bonds and stocks both have advantages and disadvantages.
The duration of a financial asset with fixed cash flows, such as a bond, is calculated as the weighted average of the period until those fixed cash flows are received. Duration measures the price sensitivity to yield, the rate of change of price with regard to yield, or the percentage change in price for a parallel movement in yields when an asset is thought of as a function of yield.
Duration is a gauge for how sensitive a bond’s price is to changes in interest rates. Either a percentage or a monetary value can be used to express it. To “shock” or predict what will happen to a bond when market rates rise or fall can be useful.
Reasons why bond convexities may vary
A zero-coupon bond has the maximum price sensitivity to concurrent changes in the term structure of interest rates, whereas an amortising bond has the lowest price sensitivity (where the payments are front-loaded). Although the sensitivities of the amortising bond and the zero-coupon bond differ at the same maturity, if their final maturities differ so that they have the same bond durations, then their sensitivities will be the same. That is, minor, first-order (and parallel) yield curve movements will have an identical impact on their prices. Due to their various payment dates and amounts, they will begin to alter by different amounts with each additional incremental parallel rate shift.