As an investment banker, your main goal is to make money for you and your clients. You can purchase a huge range of things on their behalf including: gold, foreign currency, and company stock. But you can also make deals for them in fixed income. The name fixed income is pretty right on the money (no pun intended) – these are debt securities that pay an amount of income at fixed intervals over a certain length of time. Pretty simple, right? But there’s a lot of variation inside fixed income that you need to understand if you’re going to be a successful investor.
The Name is Bond
This is the biggie in the fixed income market. The most basic definition of a bond is a kind of loan. If a company issues bonds and you buy one, you are basically loaning them money. In exchange, they will pay you interest on a fixed schedule for the length of the loan, or bond. When the bond expires, the company will also pay back the original amount of the bond, or the principle. Bonds are great for people who feel comfortable investing in something that they know will pay them quarterly, annually, or whenever is stipulated.
Bonds are issued by lots of different places; here are the ones you need to know about:
- Government: Government-issued bonds are considered one of the most stable investments you can make. Actually, there are three kinds of securities to go for: Treasury bills (or T-bills), which mature for up to two years; Treasury notes, that go on from three to 10 years; and Treasury bonds, which last from 10-30 years. Of course these are seen as stable because really, is the government going to default? No. But the amounts of the payments are affected by interest rates, so they’re not totally without risk.
- Municipal: These are regularly called “munis”. They are bonds that are issued by the local government or a city. Munis are also considered quite a safe investment, as cities rarely default.
- Corporate: These are issued by a company just like they would issue stock (but don’t get confused – a stock is a share in the company and a bond is a debt security). Issuing bonds is a great way for a company to raise money if they are looking to expand or for things like new offices.
Another important aspect of the bond market is the ratings. Standard & Poor’s, Moody’s, and Fitch Ratings are the credit rating agencies you need to familiarise yourself with. Bonds are rated on a scale from AAA-D. The agencies label their levels slightly differently, but in general the bonds that have a rating of at least BBB are most likely complete payments. Anything with a rating lower than that is considered a high-yield bond, more commonly is known as a junk bond. Well, the name alone should tell you all about those! Yes, they can be high yield, but they are so risky that there is a big chance the issuer will default and that that means you don’t get your money.
Derivatives
Derivatives are tricky. We’re used to seeing something, it’s got a price tag, and that’s how much it’s worth. But a derivative’s value changes based on a host of different factors. Check out our article “What are Derivatives?” for a great explanation, but here are the basic ones to learn.
- Forward: A forward contract means that someone agrees to buy something from someone else at a future date for a fixed price – got that? So say that you want to buy a car, but you don’t want to buy it for another year. The car dealership agrees to sell you the car you want in exactly one year for £20,000. Well, in a year’s time the value of the car could go up or down, depending on a lot of things. So if the value goes up, the dealership still has to sell you the car for £20,000 and that means that you have made a profit, while they have lost money.
- Option: Instead of a forward, you can buy an option instead. So, if in a year’s time the value of the car is only £18,000, but you still have that forward saying you have to pay £20,000, the option gives you the option (clever name, huh?) to opt out of the deal. That £20,000 is also called the strike price, or the price that the contract will be carried out for, if the deal happens.
- Interest Rate Swap: If you find the finance world interesting, you’ll love the idea behind interest rate swaps. Basically, this allows you to swap one cash flow for another. There are a lot of reasons for someone to do this, but let’s say that there’s a company that pays interest on a loan and that interest is floating, meaning that it changes. If the directors of that company decide they don’t like being exposed that way, they can swap their payments with another company whose interest rate payments are fixed. So Company A pays Company B their floating rate and Company B pays Company A their fixed rate. Swaps can be structured in a number of ways, but this is the most basic. Coming back to fixed income, this is another way that a particular party can ensure that they are getting a payment at a fixed interval.
So as you can see, investment banking isn’t just “buy low, sell high”. Fixed income is a useful market to understand, and an essential tool in the investment banking world.
