Fixed Income Security

A fixed income security is a debt investment that entitles its holder to a stream of interest payments set in advance, or by a stated formula, and to the return of the principal on a fixed date. The issuer, which may be a government, a company, a bank or a public agency, borrows money from investors and promises to pay it back on those terms. The best-known example is the bond, but the category also includes notes, bills, certificates of deposit, commercial paper and many asset-backed instruments.

Fixed income sits beside equities and cash as one of the main asset classes. Unlike a share in a company, it gives the holder a creditor's claim rather than ownership, so the investor's upside is usually limited to the promised payments while the main danger is that the issuer fails to pay. In the United States, most public offerings of fixed income securities are registered with the Securities and Exchange Commission (SEC), while US Treasury debt is exempt from registration.

Think of lending money to a friend who signs a note: "I will pay you a small amount every six months and give you the full sum back in five years." You know in advance what you will receive and when. A fixed income security is that note, written up formally so that it can be sold to many lenders and passed from one investor to another.

Because the payments are known, the main questions are simple. Will the borrower keep the promise? And is the fixed payment still attractive if, a year later, other borrowers are offering more? Those two questions, about the borrower's reliability and about changing interest levels, explain most of what happens to these investments.

Fixed income securities are usually grouped by who issues them and how long they run:

• Government debt. National governments borrow through instruments such as US Treasury securities, UK gilts and German Bunds; these are often treated as the market's benchmark for the risk-free rate in their own currency.
• Corporate debt. Companies issue corporate bonds and commercial paper to fund operations, acquisitions and refinancing.
• Municipal and agency debt. In the US, states and cities issue municipal bonds whose interest is often free of federal income tax, a form of tax-exempt income.
• Securitised debt. Mortgage-backed and asset-backed securities, and structures such as collateralized debt obligations, pass through payments from pools of loans.
• Short-term instruments. Bills, commercial paper and certificates of deposit maturing within a year form the money markets.

Islamic finance has its own equivalent, the sukuk, which pays returns from an underlying asset rather than interest. Hybrid instruments such as convertible bonds and preferred stock sit between debt and equity.

Most securities have a face value (also called par value), a coupon rate that sets the interest paid on that face value, and a maturity date. A $1,000 bond with a 5% coupon pays $50 a year, often in two $25 instalments, and repays $1,000 at the end. Some securities pay no coupon at all and are sold at a discount, as with US Treasury bills; others have floating rates that reset to a benchmark such as SOFR.

After issue, the security trades in the secondary market, mostly over the counter between dealers rather than on an exchange. Its price moves so that its yield matches what investors demand for that issuer and term. The most complete single measure of return for a buyer who holds to the end is the yield to maturity, and the spread of yields across maturities is drawn as the yield curve.

The fixed payments do not make these securities risk-free. The main risks are:

• Interest rate risk. When market rates rise, existing securities with lower coupons fall in price; interest rate risk is larger for longer maturities.
• Credit risk. The issuer may pay late or not at all, which is a default. Agencies publish a credit rating to signal this credit risk, and lower-rated issuers pay a wider credit spread.
• Inflation risk. Fixed payments buy less if inflation rises, which is why inflation-linked bonds exist.
• Liquidity risk. Many individual bonds trade rarely, so selling before maturity can mean accepting a lower price, a form of liquidity risk.
• Call and reinvestment risk. Issuers may redeem callable bonds early when rates fall, leaving the investor to reinvest at lower yields.

Fixed income markets are larger than stock markets in most countries. The main holders are pension funds, insurers, banks, central banks and foreign official reserve managers, who need predictable cash flows to match their liabilities. Banks also use high-quality government bonds as collateral in repo transactions.

Individual investors usually reach the market through a bond fund, a money market fund or an exchange-traded fund, which spread money over hundreds of issues. A fund, however, has no maturity date of its own, so its price can stay below its starting level for a long time after rates rise. Individual Treasury securities can also be bought directly from the US Treasury in amounts as small as $100.

In a portfolio, fixed income is used to provide income, to reduce the volatility that comes from equities and, for high-quality government debt, to act as a store of value during a recession, when central banks tend to cut rates and bond prices rise.

• Investor.gov (SEC): Bonds – FAQs
• TreasuryDirect: Marketable Securities