Asset classes: Fixed income

An asset class, as you’ll know if you’ve read our introduction to asset classes, is simply a group of assets that share similar characteristics. ‘Fixed income’ investments are assets that predominantly provide their return as fixed or floating periodic payments on the investment amount. This asset class is diverse and includes government bonds (also known as treasuries), corporate bonds, asset-backed securities, loans and insurance-linked bonds.

A simple way to think of it is that if you invest in a government bond, for example, you are lending money to the government. It will pay you interest, and at the maturity date, which is set when you make the investment, it will also pay you back your principal (your original ‘loan’ amount). Fixed income investments play a defensive role in a portfolio. Compared to shares (equities), your capital is generally more protected from a capital loss. When you invest in shares, there is no obligation for the company you invest in to repay the money invested and there is the possibility that you could lose all of your initial investment; this is the risk you take for the possibility of strong returns. With fixed income, there is an obligation for the borrower to repay that money invested so there is a far greater assurance you will get your capital back, plus the agreed regular income.

Investing in fixed income is not without risk and the 2 key risks investors should be aware of in this asset class are credit risk and interest rate risk.

Credit risk represents the risk that the borrower (the issuer of the fixed income investment) could default (i.e., fail to pay the interest and/or principal of the debt). There are varying degrees of credit risk within fixed income, depending on the entity issuing them and their credit rating. Government bonds have the backing of governments and generally carry the lowest amount of default risk. Corporate bonds are backed by the revenue of companies, and this is why, generally speaking, corporate bonds are higher risk than government bonds.

Interest rate risk represents the risk to fixed income assets that changes in interest rates have on the value of those assets. When interest rates rise (fall), bonds which pay fixed interest rates typically fall (rise) in value as investors require a discount (premium) to buy a bond that pays interest below (above) the prevailing rate in the market. This feature generally sees government bonds have defensive properties in market downturns as interest rates often fall in such downturns, seeing the market value of these bonds rise.

The long-term expected return for fixed income is lower than that of shares. What they offer instead of high returns is capital preservation, income generation and diversification within a portfolio. This is a good illustration of the investing adage that there is always a risk/return payoff – lower-risk investments like fixed income tend to offer correspondingly lower returns. As an individual investor, you’d be likely to look at increasing the defensive investments in your portfolio as you get older, and have less time to ride out market fluctuations. In the same way, we include such investments in our portfolio so we can offer our members the NGS Defensive pre-mixed investment option, for our Accumulation accounts and Income accounts, as well as ensuring that our overall portfolio is appropriately balanced.