What is Fixed Income and How It Generates Yield

Financial operations have been present long before our era. The earliest known bonds date to 2400 B.C. when a stone tablet was found in Mesopotamia. This artifact witnessed the guaranteed payment by grain, as corn was the currency of that time.

The biggest turning point, however, arrived in the 16^th century. The Bourse in the Belgian city of Antwerp has been noted as the first trading house, which laid the foundation for the Amsterdam and London exchanges later on.
The first bond, issued by the government, dates back to 1694 with the emergence of The Bank of England which was trying to strengthen its efforts against the war with France¹.

The early bond market, emerging after 1694, can be seen as unique. Many initial loans incorporated annuities and lotteries (including the “Million Lottery”), distinctly different from today’s standards. However, traditional bonds with perpetual coupon payments also coexisted. By 1752 these bonds had become stocks or ‘consols’, as they were called in the 18^th century, and offered fixed coupon payments. Nevertheless, the first long-term bonds were issued in the 20^th century, meaning that the financial investment market had undergone several different stages².

It’s interesting to note that while the form of bonds has evolved over time, the core concept of lending money in exchange for interest and principal repayment has remained consistent. While adventurous investors may pursue risky strategies, such as short selling, those seeking a more predictable source of income often find relief in the steady returns offered by fixed income investments.

In this article, we are going to narrow down several topics:

• Present-day fixed income
• Types of fixed income
• How yield is generated

We will thoroughly explore the domain and the different types of fixed income instruments available today. Whether you’re an experienced investor or a financial rookie, understanding fixed income can help you build a well-diversified portfolio and achieve your financial goals.

What is fixed income?

Fixed income, also known as debt securities, refers to investments that provide a predictable and steady stream of income over a specified period. Unlike stocks, which represent ownership in a company, fixed-income securities represent a loan to an organization, such as a government or corporation. The investor receives a predetermined interest payment, known as a coupon, at regular intervals.

Bonds: a type of fixed income

Bonds are the most common type of fixed income investment. They are essentially debt contracts issued by businesses or organizations seeking to raise capital. When you purchase a bond, you become a creditor to the issuer. Several types of bonds can be distinguished:

• Corporate Bonds: Issued by corporations to fund operations, expansions, or debt refinancing.
• Government Bonds: Issued by governments (federal, state, or municipal) to finance public projects or budget deficits.
• Treasury Bonds: A specific type of government bond issued by the U.S. Treasury.

Certificates of deposits

When discussing fixed income, certificates of deposit (CDs) should also be mentioned. CDs and bonds are considered fixed income investments, meaning they offer a fixed rate of return over a specific period. Nevertheless, we should elaborate on the specific features that can only be attributed to CDs:

• Rates can be higher than for a typical savings account.
• Known for safety, stability, and lower risk.
• Offer a fixed interest rate for a specific term.
• The timeframe can vary, from short-term to long-term.
• It should be taken into account that CDs are less liquid and can come with potential penalties for early withdrawal.

The choice between CDs and bonds depends on individual investment goals, risk tolerance, and time. CDs are ideal for short-term savings objectives due to their stability, while bonds might be more attractive to seasoned investors seeking potentially higher returns and more flexibility.

The person investing has to consider different risk factors, including inflation, tax-based regulations, and currency value.

Money market funds

Unlike bonds and CDs, a money market fund is a liquid investment that collects money from many investors to buy short-term, low-risk debt securities. A money market fund takes your money and invests it in safe, short-term loans. These loans, like those to governments or big companies, earn interest. To put it simply, it serves as a haven to keep your money while earning a small return.

Typically, money market funds are stable and secure financial resources that offer easy access to your money while providing a modest reward. Money market funds include the aforementioned CDs, treasury bills, commercial papers, banker’s acceptances, and more. They are especially useful for managing short-term financial needs due to their high liquidity and low-risk profile.

What is yield?

Yet, the most important factor that shouldn’t be overlooked is financial gain also known as “yield”. Yield refers to the return an investor earns on a bond investment. While the coupon rate is the stated interest rate, the actual yield can fluctuate due to different factors like market interest rates and bond prices; social and economic changes also greatly affect the market.

How does fixed income generate yield?

The primary way fixed-income investments generate yield is through interest payments. When you purchase a bond, you’re lending money to the issuer. In return, the issuer agrees to pay you a fixed interest rate (coupon rate) at regular intervals (usually on a semiannual basis). This is the most straightforward way to earn a return on your investment.

We can enumerate these components for fixed income yield:

• Coupon Rate: The stated interest rate on the bond. This is the fixed amount of interest you’ll receive per year relative to the bond’s face value (also known as “par value”).
• Maturity Date: The date when the bond issuer will repay the principal (the original amount borrowed).
• Par Value: The face value of the bond, which is typically $1,000.
• Yield to Maturity (YTM): This represents the total return anticipated on a bond if held until its maturity date. It takes into account the bond’s current market price, coupon rate, and time to maturity. 
• Yield to Call (YTC): This means that the investor can regain his return before the maturity date. This usually comes with a penalty fee for the companies.

Conclusion

Fixed income investments play a valuable role in any portfolio, providing a stable and steady monetary reward. From bonds to certificates of deposit, choose the type of investment that best suits your short-term or long-term plans. 

It’s also important to consider factors like inflation and taxes when making investment decisions, but fixed income remains a time-tested strategy for generating yield and achieving your financial goals.

1.  Ellison, M., & Scott, A. (2020). Managing the UK National Debt 1694–2018. American Economic Journal Macroeconomics, 12(3), 227–257. https://doi.org/10.1257/mac.20180263 ↩︎
2. Ibid. ↩︎