Market Basics: Fixed Income
Fixed income comprises investments in which the borrower, frequently referred to as the issuer is legally bounded to make a fixed payment to the lender on a fixed schedule.
Fixed income securities can be compared with equity securities as stocks which give the buyer ownership over a part of the company. As mentioned in any corporate finance course, the payment of dividends is not mandatory for the issuer of equity.
In order to finance an investment such as an acquisition or the purchase of new equipment, the company must raise money. This can be achieved either by issuing equity (stocks) or by issuing debt (bonds, loans). A key difference between equity traders and fixed income traders is that the latter trades on a different platform. While equity traders are active on stock exchanges, fixed income traders are more active in so-called over-the-counter (OTC) exchanges.
The term fixed relates to the pre-specified amount and schedule of payments. If the borrower is unable to make the payment, they will typically face a penalty, although the exact ramifications depend on the law that applies to the host country of the firm in question. In extreme cases, the lender possesses the power to force the firm into bankruptcy in case of an inability to pay.
Fixed income is used by governments, companies and usual households. One common example is a retirement fund which provides the same rate of return every year. This is a key part of the fixed income investment strategy.
What type of person would go for fixed income and why?
Fixed income as an investment strategy highly depends on the level of risk the buyer is willing to accept. A person with limited capital to invest, but not afraid losing part of it will opt for equity investments, as the risk-return rate is significantly higher. The person can receive higher returns or lose more money.
Nonetheless, a household which has considerable capital and prefers certainty over the possibility of high returns should invest in fixed income securities. A key component involved here is the time span that the household is willing to wait. Over decades, fixed income arguably offers greater risk-adjusted returns than many equities.
Corporate and government bonds can further be used as a safe asset in an investment portfolio. The investor should use those as a hedge against risk if opting for an equity-based trading strategy.
So what are the typical examples of fixed income securities?
The most popular fixed income product remains the bond. This will pay the investor a fixed interest rate over a certain principal value. They can be issued by governments, municipalities or corporations. Some examples of bonds have been provided below for greater understanding.
-US Treasuries: Treasury bills: <1year
Treasury notes: 2y-10y
Treasury bonds: 10y-30y
-Sovereign bonds enable foreign investors to use their local currency in order to invest in the issuing government.
-TIPS (treasury inflation protected securities) offers a rate measured by the consumer price index and is used to protect investors against the effects of inflation by adjusting the interest rate received by the buyer to changes in the inflation rate.
-Municipal bonds are issued by a state or county.
-Corporate bonds are issued by companies. They are classified under different ratings such as Moody’s and S&P depending on their risk for the investor.
What does the job “fixed income trader” entail?
The main responsibility of a fixed income trader is to correctly identify the financial product that matches the demands of the client. Subsequently, the trader will actively manage daily trading decisions, including the amount and time of the order. This is further monitored by the risk department of the bank and must fit the regulatory policies of the country.
While the job might seem repetitive, a trader must be extremely creative, while benefiting from financial engineering skills to successfully execute innovative trading approaches that are exactly in line with the client’s demand.
The qualifications of a fixed income trader typically include at least an undergraduate degree (preferably related to business, mathematics or accounting). The main challenge is to think fast and react in accordance with the computations and analyses that have been made in order to execute the transaction.
The salary of a fixed income trader will be above average. The entry salary will be around $65k and high salaries can amount to $200k. Most of the time, the compensation package further includes incentivization such as bonuses based on performance.