Introduction
Fixed-income trading involves buying, selling, and trading securities that offer a fixed return in the form of interest, such as bonds, debentures etc. They provide assured return on investments with the repayment of the principal amount at maturity. Fixed-income securities earn money in two ways: through interest payments received periodically, and through capital gains, that is selling the securities before they mature at a profit. This type of investment is very useful for those who anticipate stable earnings and ensure the diversification of risks in their investments.
Examples of fixed-income securities are government securities, company bonds, and certificates of deposit.
What is Fixed-Income Trading?
Fixed-income trading involves the selling and buying of fixed-income securities on the over-the-counter markets commonly known as OTC markets. Also, the fixed-income market has relatively low transaction costs, it is a very competitive market, and it is comprised of a large number of agents of different kinds. The fixed-income securities market is mainly divided into primary enterprises and institutional investors.
Factors Affecting Fixed-Income Trading
The following factors affect fixed-income trading:
Credit/default risk:
This type of risk is relative to credit/default risk and is defined as the possibility of the issuer to fulfill their financial obligations and, thereby, their credit worthiness. Credit rating and yield bear an inverse relationship meaning that as one increases the other decreases. When the credit rating of the issuer is low, the yield on the bond will be higher due to high credit risk and vice versa. Since fixed-income analysts are sensitive to changes in the credit rating of the issuer, a change in its credit rating impacts the outstanding fixed-income securities.
Interest rate risk:
The price of debt securities has an inverse relationship with interest rates. There is an inverse relationship between interest rate and demand. There is a direct relationship between interest rate and yield. Interest rate risk is experienced when the yield of the debt securities is affected by a change in interest rates.
Reinvestment rate risk:
This is the possibility that resulting from a reduced interest rate, the amount of options in terms of reinvestment of the interest income earned at higher or at par with the current rates in the market.
Price risk:
In the case of adverse movements in the price levels, price risk arises whereby the investor does not obtain the required price while disposing of a bond or other debt security in the secondary market. This is quite essential for investors who wish to get back the principal amount before the due date for the maturity of the securities because they cannot get back the actual price for which they have bought securities. Instead, they get the value depending upon the current market value, which may be cheaper or dearer in a way.
Purchasing power risk:
Fixed-income sectors focus on the real rate of return on investments.
Real Rate of Return = Actual Rate of Return – Inflation Rate
Inflation works to the effect of eroding the purchasing power of the principal invested and the investment income. It is clear that the level of inflation has an inverse relationship with the real rate of return. The real rate of return is inverse relation to the inflation rate of inflation thus, the higher the inflation rate, the lower the real rate of return. When the level of inflation is high it may cause a negative real rate of return on fixed income investment by the investor.
For example, let the interest payment be 3% on a bond that was purchased by a bondholder while the inflation rate is at 5%, meaning that the bondholder is receiving a real rate of return of (-) 2%.
Reason to Invest in Fixed-Income Securities
To achieve different investing goals, an investor can invest in different types of fixed-income securities:
- Capital appreciation:
Those who seek to achieve the highest return on investment should focus primarily on low-rated securities, for example emerging market debt or high-yield bonds. If the interest rates are expected to decline, investing in government bonds and long-term maturity corporate bonds should also produce good capital appreciation. Corporate bonds often come with higher returns compared to government bonds because the latter have higher risks.
- Income:
Most of the fixed income securities offer some form of constant coupon Thus, only zeros coupon securities provide no coupon payment to the investors. This makes the fixed-income in the market particularly appealing to investors who have their primary investment objective of generating income for themselves.
- Safety:
Conservative investors who focus mainly on safety should invest in securities that have a relatively low duration, less than five years to minimize the effect of interest rate Change and invest in high-ranked securities to minimize default risk. Examples of these debt securities include U. S. Treasury bills, money market instruments such as certificates of deposits, short-term corporate debts, and municipal bonds by highly rated municipalities.
- Tax advantages:
One common strategy that many investors employ whenever they want to maximize their after-tax income is to invest in municipals because the income received from such bonds is, most of the time, tax-exempt.
If you want to invest in fixed-income securities, there are many types and ways of approaching it that you can take. Fixed-income investment is essentially less risky however investors are advised to effectively research any fixed-income trading cost opportunity before investing in it. Thus, when choosing the investments to make, your goal is to ensure that you are getting the best value for your money.
Conclusion
Fixed-income trading involves trading in securities that offer a fixed return, such as bonds. Although it is not a very risky type of investment, rates of return can be lower than other investment types. It is important to avoid losing your investment, compare the opportunity cost and the grossp return and only disclose your account details to those you trust. If you are informed and careful, you can utilize fixed-income trading to help you meet your objectives.
FAQs
Here are some FAQs on fixed income trading:
Q1: What is trading in fixed income?
A: Purchasing of securities that have fixed income such as bonds and debentures.
Q2: What are the advantages of trading in fixed income securities?
A: Fixed income, lower risk and diversification of investment instruments.
Q3: What are the risks associated with fixed income trading?
A: Credit risk, interest rate risk and liquidity risk.
Q4: How does interest rate impact the trading of fixed income?
A: In essence, when interest rates go up, bond prices go down and the other way around.
Q5: What do you understand about government and corporate bonds?
A: Government bonds are relatively less risky but corporate bonds offer better returns.
Q6: What are the steps to getting involved in fixed income trading?
A: Trade directly with a broker or invest in a mutual fund company that deals with the shares.
Q7: How much capital is needed to start trading fixed income?
A: It depends on the security and the broker to be used, but it is usually between 1,000 to 10,000 Rupees.
Q8: What is the normal holding period of fixed income securities?
A: It may take a few months to several years depending on the level of security required.