What is the fixed income market?
“My word is my bond” is a common English statement that suggests a promise that is strongly backed by the character of the person making the statement. The word bond has a high significance in the world of fixed income investing. It is an instrument that denotes the promise of the borrower, or issuer of the bond to repay the principal and interest as per the terms agreed in advance.
Interchangeably used, the terms bond or debenture denote the debt owed by a borrower to a lender. A lender is actually an investor in the paper or instrument that is issued by the borrower that acts as an IOU, or loan document listing down the terms of the investment. This is actually not very different in principle from the terms of borrowing a bank loan.
The kind of instrument or product available to the investor must have some standard terms. Some of the most obvious and essential terms are:
• the return that the investment will offer as interest,
• how often the interest is paid (also called the “rests”), and
• when the principal will be repaid (in a single “bullet” payment, or in installments).
Unlike other investments, such as equity shares and commodities the basic returns feature of a fixed income instrument is to set the returns. Market players use the jargon coupon for the interest rate that the bond pays. As with a home mortgage (loan), this could be fixed or floating. Either way, this is to compensate the investor for a few services and risks she takes.
A difference in the returns profile between equity and debt (or fixed income) asset classes is that the dividend yield of the BSE Sensex is about 1.5% and most of the returns are from capital appreciation, while bond interest yields are high and capital appreciation is lower in relation. Over the long term, however, the returns are comparable. To take an example, over 25 years from 1994 to 2019 the G-Sec index has outperformed the Sensex!
Investors need to be compensated for the diminishing value of their money. Inflation is an old phenomenon but has severely impacted the future value of money in the twentieth century. Returns to an investor must ideally be higher than inflation, which means that a real rate of return must be earned on the investment. If the rate of return is not higher than the rate of inflation, there is erosion in the investor’s capital which defeats the purpose of investing.
There is also a risk in lending (lending is essentially what purchasing a bond or making a fixed deposit involves). Occasionally the borrower may be unable, or unwillingly to repay the money borrowed. The returns profile or yield of the bond reflects the relative risk of the bond – higher returns or yield is compensation for the risk of possible default or delay in repayment. Besides interest, bonds also offer the potential for capital appreciation. Now that’s an interesting topic for our next blog!