Fixed Income Investing
What is fixed income investing?
Fixed income is an investment approach focused on preservation of capital and income and refers to any type of investment under which the borrower is obliged to make payments of a fixed amount on a fixed schedule. For example, the borrower may have to pay interest at a fixed rate once a year and repay the principal amount on maturity. Therefore, fixed income securities are debt instruments that pay a fixed rate of interest. These can include bonds issued by governments or corporations, CDs, money market funds, and commercial paper such as a Loan Note.
Fixed income securities can be contrasted with equity securities, often referred to as stocks and shares, that create no obligation to pay dividends or any other form of income.
Investors in fixed income securities are typically looking for a constant and secure return on their investment. For example, a retired person might like to receive a regular dependable payment to live on like a gratuity, but not eat into the principal. They can buy a bond with their money and use the coupon payment (the interest) as that regular dependable payment. When the bond matures, or is refinanced, the person will have their capital returned to them. The major investors in fixed income securities are institutional investors, such as pension plans, mutual funds, insurance companies and other high net worth and sophisticated investors.
What are the potential benefits of fixed income?
For the past two decades, the stock/bond correlation has been consistently negative (with the exception of 2022), and investors have largely been able to rely on their bond investments for protection when equities sell off. Depending on your financial goals, fixed income investments can offer many potential benefits, including:
Diversification from stock market risk
Fixed income is broadly understood to carry lower risk than stocks. This is because fixed income assets are generally less sensitive to macroeconomic risks, such as economic downturns and geopolitical events. If you’re seeking to grow your wealth investments over time to save for retirement or other long-term goals, you probably hold a significant amount of stocks in your portfolio. But by allocating a portion of your portfolio to fixed income investments, you can potentially help offset losses when stock markets swing.Capital preservation
Capital preservation means protecting the absolute value of your investment via assets that have a stated objective of return of principal. Investors who are closer to retirement may rely on their investments to provide income. Because fixed income typically carries less risk, these assets can be a good choice for investors who have less time to recoup losses. However, you should be mindful of inflation risk, which can cause your investments to lose value over time.Income generation
Fixed income investments can help you generate a steady source of income. Investors receive a fixed amount of income at regular intervals in the form of coupon/interest payments.
Types of Fixed Income Products
The most common example of a fixed income security is a government or corporate bond. The most common government securities are those issued by the U.S. government and are generally referred to as Treasury securities/T-bills or if issued by the UK government these are referred to as Gilts.
However, for investors who hold the ‘classic’ portfolio mix with 60% in stocks and 40% in bonds, or one similar to it, this year has been tough. From the start of 2022 through September 28, a 60/40 portfolio invested in line with benchmark U.S. stock and bond indexes lost 20%. Normally, you would expect low (or negative) correlation but in response to high inflation, central banks around the world are raising interest rates (and because bond prices and interest rates move in opposite directions), bond markets have suffered double-digit declines.
Another form of fixed income security is a Loan Note, whereby a property development company can raise capital in order to fund the building of commercial assets, that have already been either leased (for example to global brand names) or sold (often to institutions or pension funds) before the project even commences.
How does a Property Loan Note Generate Income?
In simple terms the same principles mentioned above still apply. The lender (investor) loans (invests) capital with the borrower (property developer) and the developer agrees to pay a rate of interest (yield) to the lender (investor). The property developer will use the borrowed capital and repay it at the end of the agreed term.
Property Loan Notes in Detail
Opportunities are appraised quite differently to how a traditional lender might do this. Key to mitigating speculative risk is identifying the end user, both before funds are committed and commencing with the project. As part of the property development business, with a proven track record (i.e. ‘preferred partner’) agreements can be made prior to land purchase with, for example, housing associations, institutions and pension funds, as well as global brand name retailers such as Aldi, Lidl, Costa, Starbucks and McDonald’s. Once a potential property development project has been identified planning permission is applied for. Once planning approval has been obtained in writing, funding is usually sought and Loan Notes are made available. Once the capital is received in the developers bank account interest is paid as agreed in the Loan Note T&Cs.
The Loan Note may be ‘development’ specific or open ended and the capital used on other projects.
The loan note security is fixed - via a first legal charge and/or debenture (floating charge). To mitigate potential risk, the investor should look for fixed income providers that have regulated entities appointed as Trustees in order to have security against the underlying assets of the fixed income loan note. The Trustees hold the assets and any liabilities ring-fencing them, protecting the lenders (investor) and borrowers (property developers) interests as much as is practical.
Special Purpose Vehicles
This type of limited company/security trustee is called a Special Purpose Vehicle (SPV) and is invariably a temporary holding measure until the next stage. The land or relevant property is bought using the borrowed capital and often registered to the SPV.
Once detailed planning permission has been granted the development may be sold on to a large investment institution. The SPV property borrowing may also be refinanced and be retained by the property developer to be used as rental property for example. In this case the SPV may be closed once all lenders (investors) have been repaid and the assets transferred across to the property developer.
Either way it is at this stage the loaned capital is usually returned to the lender (investor) dependent on the Loan Note terms. Some Loan Notes allow you to continue investing and may pay bonuses for doing so.
In summary, fixed income investing has traditionally been a significant part of most investment portfolios. There are a range of debt instruments which can be used, and traditionally government and corporate bonds have been the ‘default’ choice. Normally, you would expect low (or negative) correlation with the equity component of an investment portfolio but in response to high inflation, and rising interest rates, the protection offered by bonds has failed in 2022. Since more turbulence may be on the horizon, greater diversification among assets with low-correlation to one another can offer long-term benefits. If poor performance in one investment can be offset by better performance in another, then extreme losses in the overall portfolio may be reduced. And if you can preserve more in a market downturn, you’ll have more capital working for you when the cycle reverses and improves. Fixed income Loan Notes are not widely advertised and are available only through specialist brokers. Depending on your requirements, the next step is to start the application process, so that you receive step-by-step guidance on the fixed income investment which works best for you.
If you would like to discuss any area of personal finance, the author can be contacted at dermot.monaghan@holbornassets.com or simply use the Book A Call Back button at the bottom right of your screen.
