Fixed income

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Fixed income refers to any type of investment that is not equity, which obligates the borrower/issuer to make payments on a fixed schedule, even if the number of the payments may be variable.[1] A common type of fixed income investment is a bond. Other common types are savings bonds, such as Canada Savings Bonds, and guaranteed investment certificates (GICs) issued by a variety of financial institutions. Some investors also classify preferred shares as fixed income for asset allocation purposes, while others do not. There are arguments that can be made by either side and there is no clear consensus. It is left to the individual investor to determine the classification that makes the most sense in their situation.

Types

Bonds

A bond is a negotiable certificate that acknowledges the indebtedness of the bond issuer to the holder. It is negotiable because the ownership of the certificate can be transferred in the secondary market. It is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) to use and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals (semi annual, annual, sometimes monthly).[2]

In Canada, bonds are issued by the Government of Canada, provincial governments, municipalities, agencies and corporations.

The following descriptions are not mutually exclusive, and more than one of them may apply to a particular bond.

Term deposits

Investopedia defines a term deposit as: "A deposit held at a financial institution that has a fixed term. These are generally short-term with maturities ranging anywhere from a month to a few years. When a term deposit is purchased, the lender (the customer) understands that the money can only be withdrawn after the term has ended or by giving a predetermined number of days notice."[3]

Terminology

Tthere is some important terminology used by the fixed-income industry:

  • The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond) and pays the interest.
  • The principal of a bond – also known as maturity value, face value, par value – is the amount that the issuer borrows which must be repaid to the lender.[1]
  • The coupon (of a bond) is the interest that the issuer must pay.
  • The maturity is the end of the bond, the date that the issuer must return the principal.
  • The issue is another term for the bond itself.
  • The indenture is the contract that states all of the terms of the bond.

Canadian investors can generally find a copy of the indenture (also known as the prospectus) from System for Electronic Document Analysis and Retrieval (SEDAR). A review of this document can be useful to understand all the terms of a bond you may be considering.

Pricing and yields

Yield is defined as:[4]

Current Yield = Annual dollar coupon interest / Price

Canadian newspapers and websites carry sections listing current pricing and yields of various benchmark bonds. These prices are typically wholesale prices (and therefore yields) and therefore are not available to the retail investor who is buying bonds.

Accrued interest

The purchaser of the bond is obligated to pay the seller the accrued interest due on the bond at the settlement date. Canadian conventions on calculating accrued interest are generally as follows:[5]

  • For money market instruments with less than one year to maturity, an "actual/365" day count convention is used. This is similar to American practice.
  • For most bonds or GICs, an "actual/365" day count convention is also used. This differs from American practice, which is usually "actual/actual" for terms longer than one year.

Risks

Generally speaking, when looking at a fixed income, you need to consider different types of risk.

See also

References

  1. Wikipedia, Fixed income, viewed June 18, 2012
  2. Wikipedia, Bond, viewed June 19, 2012
  3. Term Deposit Definition | Investopedia, viewed November 17, 2012.
  4. Bond yield, Bogleheads wiki.
  5. Investment Industry Association of Canada, Canadian Conventions in Fixed Income Markets - A Reference Document of Fixed Income Securities Formulas and Practices, Release: 1.1, viewed June 25, 2012.

External links