Fixed income investing explained

What is fixed income investing?

Fixed income definition and how it works

The meaning of fixed income is straightforward: it refers to investments that pay you a set amount of income at regular intervals, typically until a specified maturity date. When you invest in fixed income securities, you are essentially lending money to a borrower, whether that is a government, a corporation or another entity. In return, the borrower agrees to pay you interest, often called a coupon, and to repay your original capital at the end of the term.

Think of it as like a formal IOU. You hand over a sum of money. The borrower pays you interest on a schedule, for example every six months. When the bond matures, you get your original sum back. The word ‘fixed’ refers to the predictable nature of those interest payments, not a guarantee that everything will go smoothly.

Fixed income investing covers a broad range of financial instruments, but bonds are the most common. When people discuss fixed income investment, they are usually talking about bonds or funds that hold bonds.

Types of fixed income securities

Several fixed income types exist, each with distinct characteristics. Understanding these helps you evaluate which might suit your goals.

Government bonds (gilts)

In the UK, government bonds are called gilts. When you buy a gilt, you lend money to the UK government. In exchange, the government pays you interest and returns your capital at maturity. Gilts are issued with various terms, from short-dated bonds maturing in a few years to long-dated bonds stretching over decades.

Gilts are generally considered lower risk than corporate bonds because they are backed by the UK government’s ability to raise taxes and issue currency. However, lower risk does not mean no risk. Gilt prices can fall, particularly when interest rates rise, and you could receive less than you invested if you sell before maturity.

Corporate bonds

Corporate bonds work similarly to gilts, except the borrower is a company rather than a government. Companies issue bonds to raise capital for expansion, acquisitions or refinancing existing debt.

Because companies can default on their obligations, corporate bonds typically offer higher interest rates than gilts to compensate for this additional credit risk. The interest rate a company must pay depends largely on its creditworthiness. Investment-grade bonds come from financially stable companies, while high-yield bonds, sometimes called junk bonds, come from companies with weaker credit profiles and carry greater risk of default.

Fixed income funds

Rather than buying individual bonds, many investors access fixed income through funds. Fixed income funds pool money from multiple investors to buy a diversified portfolio of bonds. This approach offers some practical advantages:

• Diversification: A fund might hold hundreds of different bonds, spreading risk across many issuers.

• Accessibility: Some individual bonds require minimum investments of tens of thousands of pounds, while fund units can often be purchased for much smaller amounts.

• Professional management: Fund managers handle the research, trading and reinvestment of income.

Fixed income funds come in various forms, including unit trusts, open-ended investment companies, exchange-traded funds (ETFs) and investment trusts. Each structure has different features, costs and tax implications worth understanding before investing.

Fixed income vs equity: Key differences

When comparing fixed income vs equity, you are looking at two fundamentally different relationships with a company or government.

• With fixed income bonds, you are a lender. You have a contractual right to receive interest payments and your capital back. If the issuer runs into trouble, bondholders generally rank ahead of shareholders in the queue to recover money. However, your upside is capped at the agreed interest rate.

• With equities, you are an owner. You share in the company’s profits through dividends and capital appreciation. The potential returns are uncapped, but so are the potential losses. Shareholders sit at the back of the queue if a company fails.

*Subject to issuer default/restructuring

Neither is inherently better. They serve different purposes and behave differently under various market conditions.

Potential benefits of fixed income in a portfolio

Fixed income securities can play several roles within a diversified portfolio. Understanding these roles helps you decide how they might fit your circumstances.

Regular income is the most obvious benefit. If you need predictable cash flow, perhaps in retirement, the scheduled interest payments from bonds can help meet that need. Unlike equity dividends, which companies can cut or suspend, bond coupons are contractual obligations, although payments can still be missed if the issuer defaults.

Diversification is another consideration. Bond prices often, though not always, move differently from equity prices. During periods of stock market stress, high-quality bonds have historically provided some cushion. This relationship is not guaranteed to hold in all conditions, and recent years have shown that bonds and equities can fall simultaneously.

Capital preservation matters to some investors. While bonds can lose value, high-quality short-dated bonds tend to be less volatile than equities. If you have a specific goal with a defined timeline, certain fixed income investments may help reduce the chance of a significant loss near that date.

Risks to consider before investing

Fixed income sounds reassuringly stable, but these investments carry meaningful risks. Do not let the word ‘fixed’ create a false sense of security.

Interest rate risk

Bond prices move inversely to interest rates. When rates rise, existing bond prices typically fall. When rates fall, bond prices typically rise.

Why does this happen? Imagine you hold a bond paying 3% annually. If newly issued bonds start paying 4%, your 3% bond becomes less attractive. Its price must fall until its effective yield matches the market rate.

This matters most if you need to sell before maturity. Hold to maturity, and you typically receive your original capital back, provided the issuer does not default or restructure its debt (and subject to any charges/tax). But many investors do not hold to maturity and bond funds never mature at all.

Longer-dated bonds are more sensitive to interest rate changes than shorter-dated ones. A small rate increase causes larger price drops in 30-year bonds than in two-year bonds.

Credit risk

Credit risk is the possibility that the bond issuer fails to pay interest or return your capital. Governments can default, though it is rare for major economies. Companies default more frequently, particularly during economic downturns.

Credit ratings from agencies like Moody’s, S&P and Fitch provide one measure of default probability. However, ratings are opinions, not guarantees. The 2008 financial crisis demonstrated that highly rated securities can still cause significant losses.

Diversification across multiple issuers helps manage credit risk. This is one reason fixed income funds appeal to many investors.

Inflation risk

Inflation erodes your purchasing power. For example, if you receive 3% interest on your capital but inflation is running at 5%, your real return is negative. You can buy less with your interest payments than before.

Conventional bonds offer no protection against unexpected inflation. Index-linked gilts, where payments adjust with inflation, provide some hedge but come with their own complexities and are not immune to capital losses.

How to access fixed income investments in the UK

UK investors have several routes into fixed income.

Individual gilts can be purchased through the UK Debt Management Office or via stockbrokers. You will need a dealing account and should understand the pricing conventions for gilts, which differ from equities.

Individual corporate bonds are harder to access. The UK retail bond market is less developed than in some countries. Minimum deal sizes can be substantial, and liquidity – the ease of buying and selling – varies considerably.

Fixed income funds are the most accessible route for most investors. You can invest through platforms, stockbrokers or directly with fund managers. When selecting a fund, examine its objectives, holdings, costs and the types of bonds it owns. A fund labelled ‘fixed income’ might focus on gilts, corporate bonds or a mixture of both. It might concentrate on UK bonds or invest globally.

ETFs offer another option. These trade on stock exchanges like shares and often track bond indices. Costs are typically lower than actively managed funds, but you get market returns rather than attempting to beat them.

Is fixed income investing right for you?

The answer depends on your circumstances, goals and temperament. No single investment type suits everyone.

Consider your time horizon. If you need the money within a year or two, even high-quality bonds carry meaningful price risk. If your horizon stretches decades, you have time to ride out short-term fluctuations, and equities may play a larger role.

Consider your income needs. If you rely on investment income to pay bills, the predictable coupons from bonds have clear appeal. If you are accumulating wealth and reinvesting everything, income predictability matters less.

Consider your risk tolerance. How would you react to seeing your investments fall 20% or 30%? Historically, bond losses have tended to be smaller than equity losses during market downturns, though they can still be substantial, particularly in long-dated or lower-quality bonds.

Consider your existing holdings. If you already own property, a workplace pension invested in a diversified fund and some individual shares, adding fixed income might improve your overall diversification. If you own only cash savings, moving straight into long-dated corporate bonds might represent a larger step than you realise.

Fixed income investment is one tool among many. It is neither superior nor inferior to equities. The question is how it fits within your broader financial picture.

Summary

Fixed income investing means lending money in exchange for regular interest payments and the return of your capital at maturity. The main fixed income examples include government bonds like UK gilts, corporate bonds from companies and funds that hold portfolios of these securities.

The appeal lies in predictable income, potential diversification benefits and typically lower volatility compared to equities. The risks include interest rate sensitivity, the possibility of issuer default and the erosion of returns by inflation. These are real risks, not theoretical ones.

UK investors have several routes for accessing fixed income bonds: buying individual gilts, investing through fixed income funds or using exchange-traded products. Funds offer simplicity and diversification but come with ongoing charges and remove your control over individual holdings.

Before investing, understand what you own, why you own it and how it might behave under different conditions. Past performance does not indicate future results. If you need help determining what is appropriate for your situation, consider speaking with a qualified financial adviser.

This article is for educational purposes only and does not constitute financial advice. All investments carry risk, including the potential loss of capital.