What is Fixed-Income Trading?

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

A big universe of fixed income securities is out there to meet many investors' needs. This lesson will introduce you to this world and how you can determine which fixed income investments are right for your investment portfolio.

What is a Fixed Income Security?

Joe has been investing in stocks for a long time. He decides that it's time to diversify his investment portfolio by putting some of his money into fixed income. Let's join Joe as he learns about the world of fixed income and executes a trade.

The first thing Joe finds out is that fixed income securities aren't stocks! Fixed income securities are debt, while stocks represent equity or ownership. When Joe buys a fixed income security he is lending the company money.

They will pay him interest periodically plus return his principal at maturity. This type of fixed income security is called a bond. The majority of fixed income securities are bonds.

Trading Fixed Income Vs. Trading Stocks

Joe next finds out about two major differences of trading fixed income versustrading stocks:

  1. The universe of fixed income investments is much larger. Think of it like this, your local utility company has a few listed stocks representing common and preferred equity. The same company may have hundreds of different bond issues! Multiply that by all of the companies with listed stocks and you have a much larger world of fixed income investments.

  2. Price transparency is not the same. Up to the minute prices for major stocks are readily available online. Many bond issues are lightly traded, so the most recent transaction might have been weeks or months ago. In a fast changing financial world, that old price might not apply to the current situation. On top of that, many trades involve dealers and institutions that do not have to disclose transaction prices.

The good news is that the big universe of fixed income securities means that something is there to satisfy just about any investment goal. The bad news is that Joe is going to really need to determine just what his fixed income goals are.

Investment Goals

Here are some guidelines he should follow for setting his goals:

  • Safety

If Joe is seeking safety and low risk, he should focus on securities with the highest credit rating and the shortest maturity. US Treasury Securities and CD's would be appropriate if safety is Joe's goal. In return for the low risk though, he needs to remember that these securities do not pay a high rate of interest.

  • Capital Appreciation

If Joe is seeking higher returns and is willing to take on the added risk, he should focus on corporate bonds with lower credit ratings, and emerging market issues.

  • Tax Advantages

Bonds issued by local municipalities have low returns, but the interest is tax free! This feature might help Joe lower his tax bill. The tax impact of bond investments differs from one taxpayer to another. So the after-tax return should always be part of the investment decision.

  • Maturity

Bonds are available in many different maturities. As a rule, bonds of the same quality will pay higher returns on longer maturities. So Joe will be able to get a higher return on a bond that matures in twenty years than from a bond that matures in ten.

There are other maturity considerations too. An investor saving for a child's education, for example, might want a bond that matures right when their child will be starting college.

Purchasing Fixed Income Securities

Many fixed income securities can be purchased directly by investors. The world of US Treasury securities is available on a website called TreasuryDirect.gov. Different types of CD's are available from banks and financial institutions.

Joe has decided he is looking for higher returns than US Treasuries. He is focusing on corporate bonds, and he wants to keep the money there until he retires in ten years, so he wants a maturity of ten years or longer.

The first thing Joe should do is call the bond department of a brokerage firm. Once he explains his criteria based on his goals, he can have them check their inventory of bonds to see what they have or can obtain that fit his needs.

Joe is glad to hear that they have five bond issues that he might be interested in. The lady in the bond department is emailing him the information on them today!

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