First and foremost, investing in fixed income assets provides diversification from other asset classes such as equities, property, and currencies. Having a low correlation to other asset classes provides the ideal platform to reduce overall risk within an investment portfolio. Figure 1 illustrates the rolling returns of the six major local asset classes over the last ten years. Fixed Income assets, such as bonds and cash, clearly have lower volatilities and corelations to the more aggressive asset classes such as equities and property.
Figure 1: Asset Class Returns
Fixed income investments generally focus on capital preservation, while providing a level of interest income over time. These interest payments come in the form of coupons, interest distributions and repayment of the capital at the end of the investment term. This predictability of income payments therefore enhances the overall stability of one’s investments; yet another benefit of being invested in fixed income assets.
Investing in fixed income assets does not, however, come without any risk. Fixed income assets are at times more susceptible to risks such as changes in interest rates, inflation, and the credit quality of the issuing entity. Careful portfolio construction and monitoring can, however, reduce these risks to manageable levels while providing returns commensurate with the defined investment objectives and performance targets.
Understanding the Inverse Price / Yield relationship
The most formidable instrument in the fixed income investment universe is undoubtedly bonds. Bonds are the primary vehicle used by treasuries to provide government funding and bonds issued by corporates form an integral part of their debt funding and management of their cost of capital.
Bonds are, however, very sensitive to the movement in interest rates. The paradoxical feature to note is that as rates rise, bond prices fall. Conversely, when interest rates fall, bond prices rise. Why is this?
When considering any investment, whether it be gold coins, fine art, or financial instruments such as equities or bonds, the value that you are willing to attach to that investment today can be derived from the value of the future cash flows from that investment. In other words, what I am willing to pay for an investment today will be the value of all the future cash flows discounted by a certain interest rate.
The cash flows are discounted as it is logical that you would want to pay less for the investment today than what it will be potentially worth in the future. This just makes good investing sense. Mathematically, this relationship can be depicted for a single period as follows:
So, when interest rates rise, you will be expecting to pay less for the investment now. Similarly, you will be expecting to pay more for an investment now when the interest rate falls. This is precisely the principle upon which bonds are constructed. As bonds have predictable future cash flows, the price that one is willing to pay today is dependent on the changes in interest rates. Simply put, interest rates go up, bond prices go down. Likewise, interest rates fall, bond prices rise.
Figure 2: Bond Price vs Yield
Fixed income assets are defensive in nature and provide great diversification relative to other asset types. They are often highly liquid and pay a steady stream of income over the life of the asset. Their cash flows are thus predictable, though not without risk. Bonds especially are highly-sensitive to the movement in interest rates, but when well-managed, they offer valuable returns over time. Fixed income, an essential component to any credible investment portfolio.