Understanding Fixed Income

Fixed-income securities or bonds are generally thought of as safe rather boring investments, lacking the risks associated with equities. After all, no one seems to worry about the US government defaulting on its debt and US Treasuries make up a significant proportion of the bond market. In practice, though, it is possible to lose vast amounts of money by getting the bond markets wrong. Because bonds appear to have a more definable risk profile than equities, leverage tends to be more easily obtainable. And high confidence in understanding fixed-income relationships may lead to excessive leverage and unexpected out-comes, as the case of Long-Term Capital Management (LTCM) in the late summer of 1998 vividly illustrates.

Bonds are debt instruments, securities sold by governments, companies and banks in order to raise capital. They normally carry a fixed rate of interest, known as the coupon (usually paid every six months), have a fixed redemption value (the par value) and are repaid after a fixed period (the maturity). Some deep-discount and zero-coupon bonds carry little or no interest, instead rewarding the buyer with a substantial discount from their redemption value and hence, the prospect of a sizeable capital gain.

As Michael Lewis explains in Liar's Poker, his entertaining account of life among Salomon's bond traders in the 1980s, the one thing you need to know about bonds is the relationship between their prices and interest rates. In short, as one goes up, the other goes down. This is because the fixed income paid by a bond which when calculated as a percentage of its market price is its current yield is equivalent to the rate of interest. If rates go up, the relative attractiveness of newly issued bonds over existing bonds increases. And since coupons are fixed, for yields to be comparable to those on new bonds, the price of existing bonds must fall.In most developed countries outside the United States, government bonds issued in the domestic market have traditionally dominated fixed-income investors' portfolios. But with the opening of markets around the world, the range of choices has increased enormously in recent years. There are now markets not only in the government bonds of developing and transition countries (see Emerging Markets) but also for numerous other debt instruments: corporate bonds, junk bonds, stripped bonds, mortgage-backed securities, convertibles, and so on. In the United States, the Treasury bond market is now significantly smaller than the mortgage and corporate bond markets.

Credit quality has become a key issue. For example, emerging market and corporate bonds generally carry a risk premium over US government bonds, with higher yields to reflect the more variable creditworthiness of their issuers and the greater risk of default. Periodically, bonds of an entire category sovereign debt, real estate, junk become nearly worthless. Under these conditions, there is a preference for liquidity and quality, making refinancing difficult or impossible for less than top quality issuers.

Interest rates and credit risks are crucial considerations in fixed-income investing but perhaps most important of all is the expected future path of inflation. Inflation is bad for bonds, eroding their value as prices and yields, unless index-linked, fail to keep pace with rising prices. What is more, higher inflation or the prospect of higher inflation is usually associated with higher interest rates, as policy-makers tighten monetary conditions in order to try to contain inflation or protect a weakening currency (see Foreign Exchange and International Money). This makes cash more attractive, pushing down bond returns.

The yield curve is a means of comparing rates on bonds of different maturities, as well as an indication of the tightness of monetary conditions. Longer term yields are usually higher because of the greater degree of time and inflation risk. They are a good indicator of expected trends in the rate of interest and the rate of inflation. When short-term rates are higher, there is an inverted yield curve. It is vital for active fixed-income investors to look for changes in expectations about the future rates of interest and inflation. Key indicators of these are the strength of the economy and the frame-work of fiscal and monetary policy (see Economic Forecasting and Politics and Investing). Bond markets tend to like signs of economic weakness since strong growth might trigger inflation. They also like fiscal policies that dampen the economy, squeezing out inflation.

Indeed, bond traders have become increasingly effective in preventing governments from introducing policies that may reignite inflation, hence driving interest rates higher and bond prices down. Their actual or implied threat to flee the markets in response to such policies has led to them being called vigilantes, and to presidential adviser James Carville's famous remark, ''I used to think that if there was reincarnation, I wanted to come back as the President or the Pope. But now I want to be the bond market: you can intimidate everybody."