Beginner’s Guide to Fixed Income Trading (2018)

Beginner’s Guide to Fixed Income Trading (2018)

The financial markets continue to grow in size as more assets and instruments emerge or gain in popularity. Fixed income trading is one of the trading methods that have grown in popularity over time.

The U.S. bond market has grown twice the size of the domestic equity market. Despite this, the fixed income trading securities do not get as much investor or media exposure compared to the stock market. The reason for this has been said to be the bonds lacking the exciting return potential that stocks have.

Person writing in a notebook the words fixed income

What is Fixed Income Trading?

Fixed income is characterized as an investment that returns payments to you in a regular basis.

Some of the most common examples of fixed income investments are pensions, bonds, and loans. Other investments include certificates of deposits, savings accounts, money market funds, and annuities. There are also fixed income securities you can choose from. This includes bond mutual funds, exchange-traded funds, and fixed income derivatives.

Following the 2008 recession, demand for fixed income investments had hit the roof. This is mostly due to the expansionary monetary policy implemented by the Federal Reserve. The policy was able to maintain interest rates at a record low for seven years. After this, risk averse investors began to shift more of their portfolios to fixed income products. They were required to maintain the same level of payments.

Types of Fixed Income

There are four main categories that fixed income investments may fall upon. These are short-term, long-term, fixed income derivatives, and third-party fixed income payment streams.

Types of Fixed Income infographic

[Side note: Derivatives are synthetic products. Their value is taken from underlying short or long term products. They have the most potential return since you invest less of your money. However, the moment they begin to lose money, you could potentially lose much more than what you initially invested.]

Short-term

When it comes to fixed income trading, short-term products return a low rate but you only invest your money for a few months at most. These accounts have an interest rate based on the fed funds rate, or the equivalent Treasury bill rates of four years or less.

Back in 2008 when the fed funds rate was lowered to zero, earnings of these products resulted to super-low interest rates. Due to this, individual investors began shifting from short-term to longer-term investments in order to gain higher yields.

Certificates of Deposit

With certificates of deposit, you need to keep your money invested for a predetermined period. Failure to comply will result to loss of promised rate of return.

Money Market Accounts

In money market accounts, the bank pays you a marginally higher fixed rate of interest. But you still have to do something in return. it’s not too complicated so there’s no need to worry. You’ll just have to maintain a minimum amount deposited. There’s also a limit to the number of transactions you can conduct within a year.

Money Market Funds

The money market funds are a type of mutual funds found in the field of fixed income trading. These funds invest in various short-term investments. The fixed rate payment you receive is based on short-term securities. These comprise of Treasury bills, federal agency notes, and Eurodollar deposits.

It also includes repurchase agreements, certificates of deposit, and corporate commercial paper. Other bases for this investment are obligations of states, cities, or other types of municipal agencies.

Savings Accounts

Owning a savings account will entitle you with payments of a fixed rate of interest from the bank. These payments will depend of the fed funds rate. Additionally, you normally wouldn’t have any problem when it comes to adding or withdrawing whenever you want.

Short-term Bond Funds

The short-term bond funds are another type of mutual fund. These funds invest in one-year to four-year low risk bonds. Most of the holdings in these funds are corporate bonds.

Fixed income investment concept

Long-term

The interest rates in long-term accounts follow Treasury notes and bonds. Rates usually depend on the length of time the bond is being held.

Bond Mutual Funds

The bond mutual funds are known as the mutual funds that own a large number of bonds. This will give the investor the opportunity to benefit from owning bonds without going through the hassle of actually buying and selling them. Mutual funds also offer greater diversification compared to what most investors could obtain on their own.

Exchange Traded Funds

The bond ETFs have gradually grown in popularity over time. This is mostly due to them having low costs. They simply track the performance of a bond index instead of active management like a mutual fund.

Individual Bonds

This is normally how the organizations gain substantial loans. But unlike loans, you can easily buy and sell bonds just like with any other security. Normally, once the prices of stocks rise, the bond prices begin to fall.

When compared to stocks, bonds have lower return, but also lower risk. Most of the investors who turn to bonds are those who wish to avoid risk. There are also various types of bonds you can choose from. The ones considered to be the safest still are the ones issued by the government, followed by municipal bonds, and savings bonds.

Fixed Income Derivatives

Financial products under this category are able to derive their value from underlying bonds. They are mainly used as a way to hedge against potential losses. Most of those who do this are sophisticated investors, companies, and financial firms.

Asset-backed Commercial Paper

These are one year corporate bond packages that are based on underlying commercial assets. Under this class is real estate, corporate auto fleets, or other business property.

Collateralized Debt Obligations

These rely on auto loans and credit card debt when it comes deriving their value. There are also other times when they used bundles of corporate bonds in order to determine their value.

Futures Contracts

Futures contracts act as an agreement to either buy or sell an asset on a publicly-traded exchange. The asset can either be commodity, bond, currency, or stocks. The contract also has the information about when the seller will deliver the asset. They are traded on an exchange.

Interest Rate Swaps

These are contracts that give bondholders the opportunity to swap their future interest rate payments. The contract is made between someone who holds a fixed interest bond and someone holding a flexible interest bond. These contracts are traded over the counter or OTC.

There are also those referred to as Swaptions. These are options on an underlying interest rate swap. Aside from this, they are also known as a derivative based on another derivative. It is highly advisable to only use them as a way to speculate regarding the possible interest rate movements,

Mortgage-backed securities

These depend on bundles of home loans when it comes to deriving their value. In terms of the rate of return, it has the same basis as bonds. The rates of return they offer are both based on the value of the underlying asset.

Options

With options, you, as the buyer, are given the right to trade a bond at a certain price on an agreed-upon future date. The right to buy a bond is referred to as a call option. On the other hand, the right to sell a bond is known as the put option. It is also traded on a regulated exchange, just like the futures contracts.

Stack of coins growing alongside the rising levels in the chart

Third-party Fixed Income Payment Streams

There are some fixed income streams that do not rely on the value of an investment. The payment is instead guaranteed by a third party.

Fixed-Rate Annuities

These are insurance products that guarantee you receive a fixed payment over a predetermined period. The number of fixed-rate annuities is increasing since there are fewer workers receiving pensions.

Pensions

These are known as fixed payments that are guaranteed by your employer. Their value is determined by the number of years you have worked with them and on your salary. Companies, unions, and governments are the ones who mostly use pension funds. This is to ensure that there will be enough funds to make the payments. Since there are more workers who decide to retire, there are fewer companies that offer this benefit.

Social Security

These are fixed payments that become available after a certain age. You can rely on it since the federal government guarantees its delivery. The value of your social security is also calculated through the amount of payroll taxes you were able to pay. The social securities are handled by the Social Security Trust Fund.

Conclusion

There are many ways that make it seem like fixed income trading is more complicated than equities trading. This is mostly due to the great number of issues outstanding as well as the lack of transparency in the market.

Regardless, having enough information and experience about the investments and trading process will greatly help with your trading journey. Never neglect due diligence and remember that research is not something you should set aside. You need to be careful about your investments and learn as much as you can about the fixed income trading.

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