Understanding Fixed Income Options
The main fixed income options for individual investors are government bonds and corporate bonds, held directly or through bond funds and ETFs. Government bonds carry less default risk and usually pay lower yields; corporate bonds pay more to compensate for the risk that the issuer cannot repay. Two measures drive most bond decisions: duration, which shows how much a bond's price moves when interest rates change, and credit quality, which shows the risk of default. This article explains each in plain terms and is educational, not investment advice.
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A Quick Overview of Bonds
Bonds are a type of loan agreement between an investor and a borrower. The borrower agrees to pay the investor a set amount of interest in regular intervals (generally quarterly or semi-annually), and at the end of the term, the investor is returned the initial loan amount. As with any loan, the risk associated with investment in bonds is mainly related to the risk of default by the borrower. The rate of return a bond holder earns is determined by the interest rate set by the issuer of the bond and is usually kept fixed throughout the term of the bond.
Interest Rates and the Yield Curve
The interest rate, or yield represented by a bond, is a measure of how much return the investor is getting relative to the market. Generally, bonds with higher yields are regarded as being risker, since investors have to take on the risk of default in order to achieve higher returns. A yield curve is a graph of yields across bond maturities, usually for government bonds. Its shape shows how yields differ between short- and long-term bonds; an inverted curve, where short-term yields exceed long-term yields, has often been read as a sign of slower growth ahead.
Key Risks and Types of Fixed Income
Two risk measures (duration and credit risk) apply to every bond, and the two main issuer types are governments and corporations.
Duration
Duration measures how much a bond’s price is expected to fluctuate with changes in the interest rate. Generally, bonds with longer maturities are more sensitive to changes in the interest rate, so investors should be aware of the underlying duration when purchasing bonds.
Credit Risk
Credit risk is the risk that a borrower will not fulfill their obligations under the loan agreement. This is a risk that investors must consider when investing in bonds and is highly dependent on the creditworthiness of the borrower. Government debt generally has lower credit risk compared to corporate bonds, since governments have the resources to fulfill their obligations.
Government Debt
Government debt refers to the bonds issued by a government to finance its operations. Government bonds are generally regarded as less risky than corporate bonds, as it offers investors a degree of safety due to the backing of the government issuer. Government debt also tends to have a lower yield than corporate bonds due to the relative safety of the investment.
Corporate Bonds
Corporate bonds are bonds issued by private corporations to finance their operations. Corporate bonds are generally higher yielding than government debt, but investors must take on the risk of default, as the creditor has fewer options for recovering their original investment.
Conclusion
Fixed income options provide investors with a way to diversify their portfolio and achieve their financial goals. Understanding the different types of fixed income options available and the risk and returns associated with each can help investors make informed decisions.
MarketXLS is an Excel add-in that returns stock, ETF, and fund data as formulas, so you can track bond ETFs alongside your stocks, for example =Last("BND") for a bond ETF's price and =DividendYield("BND") for its yield.
To learn the basics of buying stocks, see how to buy stocks.
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Related bond reading
For a follow-up on bond funds, read the How bond ETFs work guide.
