23rd January 2019 | Jacek Starobrat | Deputy Head of Portfolio Management

Fixed income investing – Model Portfolio Strategies

Fixed income investing refers to the investment whose return can be usually predictable and fixed, in terms of payment schedule and interest rate, which allows to set a fixed amount to be paid.

In general, fixed income is a type of investment under which a borrower (called e.g. bond issuer), borrows the loan, at predetermined price and pays a fixed income to the investor. It means that debt investing does not represent an ownership of the company or country but it acts as a loan.

The term “fixed income” refers to fixed and floating-rate financial instruments. Fixed income investment also means investing in securities based on debt instruments, like for example ETFs or Interest Rate Swaps.

Payments made to the lender can be paid according to agreed schedule, in different periods, for example: monthly, half-yearly, annually, etc. On maturity of the issued debt instrument, the lender pays to investor amount of interest, together with the borrowed capital (principal). The exception is a financial instruments without the maturity date, e.g. perpetual bond.

Compared to other types of financial instruments (equity, commodity instruments), fixed income instruments are more predictable in the context of payments and income and can be used as efficient way of portfolio diversification. However, fixed Income instruments are priced by the market and price of an instrument may change at any moment on the market, affecting profitability.

The most popular fixed income instruments are bonds and treasury bills. But there are also many other debt instruments based on this scheme. There are many types of bonds. And so we can distinguish: treasury and non-treasury bonds; corporate and municipal; coupon, variable coupon, zero-coupon; bonds with determined maturity for example: 2, 3, 5 and 10 years and without maturity; indexed and convertible; short and long-term bonds etc.

Important terms related to fixed income (bond) investment:
  • Issuer/borrower – the entity (it can be government, company, institution) which borrows funds by issuing fixed income financial instrument 
  • Principal – the amount the entity borrows and pays back on maturity date
  • Coupon – refers to annual interest rate that issuer of fixed income financial instrument has to pay periodically (monthly, quaterly, yearly etc) to the creditor
  • Maturity - maturity of the financial instrument. On maturity, funds borrower pays back the principal, together with coupon (if there is one) to the creditor
  • Financial instrument (bond) price – the price of the bonds is the present value of its future cash-flows
    • Clean price – market price – the price of the bond excluding the accrued interest
    • Dirty price – settlement value – the price of a bond including any interest that has accrued since the recent coupon payment
  • Yield – return on the issued instrument, considering both coupon payments and changes in the market prices of the instrument; in general if the yield is rising, the bond price is falling down and vice versa

Major and selected risk types associated with fixed income investment:

  • Interest rate risk – the risk that value of the investment will change due to changes of interest rates, such as: central bank interest rates, yields, cost of carry, cash value etc.
  • Credit risk – risk of insolvency by the issuer; risk of borrower’s default – it means that issuer/borrower may not be able to pay back the principal or coupons
  • Liquidity risk – risk that for a certain time period, financial instrument holder will not be able to trade the security in the market, which can impact the price of the instrument
  • Currency risk – risk of foreign exchange rate; financial instruments denominated in other currencies than a home currency, may be impacted on a price by the situation in other countries, regions, etc.

Major and selected risk factors related to fixed income investment:

  • Inflation/deflation – sustained increase in the prices of goods and services in the national economy, over a time period. The effect of this process is the decline in the purchasing power of domestic currency. Inflation and deflation have a direct impact on central banks which control the money supply through interest rate policy
  • Monetary policy – systematic actions performed by central banks or government authorized institutions, aimed at ensuring price stability
  • Fiscal policy – direct and indirect influence  on the economy, by government revenue collection (taxes) and spending; it has a direct impact on country credit risk
  • Credit quality – creditworthiness of the country, private companies etc; risk of default

Fixed Income Investment as a Strategy

Building a fixed income portfolio may include investing in bonds or other fixed income plain vanilla instruments, as well as bond mutual funds, certificates of deposit (CD), money market instruments and ETFs. These type of assets (fixed income) provide the widest spectrum of risk/reward profiles comparing to other asset classes.

In the context of fixed income model strategies, we are focused on investing in ETFs, based on fixed income underlying financial instruments.

An fixed income ETF or exchange-traded fund is a marketable security that tracks bonds, bonds indices or baskets of assets. It is a type o fund that owns mixture of underlying assets, such as treasury bonds, corporate bonds, other fixed income instruments and cash. ETFs are often highly diversified and cover or track different countries, regions, assets like for example: treasury yield curve index in USA or European Union, Investment Grade Corporate bonds in EU zone etc.

Portfolio manager selects portfolio’s components, based on ETFs to take a specific risk/reward profile to use advantage of the investment while controlling risk limits. The purpose of the investing is to achieve a better rate of return than the benchmark, with a limited level of risk, appropriate for highly diversified fixed income products.

​​​​​​​Notice: Golden Sand Bank ("Bank") exercised due diligence to ensure that the information contained in this publication was not incorrect or untrue as at the date of publication. All Investment products are at risk, as their value can go down as well as up. The tax treatment of your investment will depend on your individual circumstances and may change in the future. If you are unsure about whether investing is right for you, please seek financial advice. This publication is not an investment recommendation or investment advice in connection with any services provided by the Bank to the Client.