4 Asset classes
Fixed interest
Fixed interest securities are typically referred to as 'income-producing' investments. There is also the potential for a capital gain.
Bonds, the most common form of fixed interest securities, are agreements to repay a fixed amount of money at a predetermined date in the future (maturity date). Bonds are generally used by governments, banks or companies to provide finance.
When an investor purchases a bond they are in fact lending the issuer of the bond money for an agreed time. In return for this money, the issuer agrees to repay the amount in full at the end of the agreed time, and also make regular interest payments known as 'coupons', throughout this time period.
Bonds provide regular income, with potential for a capital gain
Therefore, the bondholder should receive regular income from the coupon payments, as well as the return of their capital at the end of the period.
Bonds can either be held to maturity, or they can be traded on a secondary market. Fund managers will trade bonds on this secondary market because it is possible for them to make a capital gain. This is because while the coupon payment rate and the time to maturity are fixed for a particular bond, its value or the price it can be bought or sold for in the market can change.
A profit occurs if the value of the bond increases (the interest rate decreases) between the time you purchase it and the time you sell it. Similarly a loss occurs if the value of the bond decreases (the interest rate increases) between the time you purchase it and the time you sell it. This is explained in the example below.
The relationship between bond prices and interest rates
Let's assume a fund manager holds $1,000 worth of government bonds with a coupon rate of 8%. This means that every year the fund manager will receive a coupon of $80, and will get their $1,000 back at the end of the term.
Suppose interest rates fall, and new bonds issued by the government only offer a 6% coupon rate. A potential buyer of bonds would now prefer to have the fund manager's 8% bond than the newly issued 6% bond, because the coupon payment is higher on the 8% bond ($80 a year vs. $60 a year).
Bond prices and bond rates are inversely related
So the price or value of the 8% bond will rise above $1,000 as investors are willing to pay more for this bond, because they will receive a higher income from the coupon repayments than from the 6% bond. If the fund manager sells the 8% bond in the secondary market, they will make a profit.
Conversely, if interest rates rose to 10%, a potential buyer would prefer the new government bond (with $100 coupon a year) to the fund manager's 8% bond. The price of the fund manager's bond would fall and they would make a loss.
Therefore, when interest rates fall the value of existing bonds rise, and when interest rates rise the value of existing bonds fall. There is an inverse relationship between interest rates and bond prices.
Bond yields
You may hear the term 'yield' used in the financial press in relation to bonds. The yield represents the market interest rate for a bond, and reflects factors such as the risk of investing in the bond and the term to maturity.
Whereas the coupon rate simply shows the rate of return that the issuer will pay each year based on the face value, the yield shows the actual rate of return expressed as a percentage of the market value of the bond under current trading conditions.