Today we will mainly speak about fixed-income investments. Fixed income is a type of investment whose value is dependent on the debt of the company (or government) one is investing in. In Article 2 we saw what Equity was all about. Do you remember Uncle Joe’s company, Re-Bottle? Its balance sheet is pictured again below. The debt side of the company (which is within its liabilities) is the part most related to fixed-income investments. We will see how debt is used to invest in new assets, as well as dig a bit deeper into the way different commodities and currencies relate to this same balance sheet.
What is Debt
Broadly, there are two ways of financing corporations. One is equity financing, the other is through debt financing. When we say that debt financing is in the liabilities side of the business’s balance sheet, it is because debt is owed by the company to outside investors. Debt investors don’t have any “control” right over the company initially. They also do not own the company, as well as any right to a share of the company’s profits. There are two main benefits debt investors have. Firstly, they gain interest rates on the money they lend to borrowers. These interest rates are usually fixed and do not change with the company’s performance. The second advantage there is in being a debtholder is that if the company goes bankrupt (remember, equity holders lose their money), there is still a chance of getting one’s money back. This is because, in bankruptcy, debtholders come before shareholders in priority queue: when the assets of the firm are sold to pay for what it owes, debtholders are prioritized over equity-holders. Check out how this can impact the dividends a business releases with the excel file you can download at the end of this article.
There are two ways a firm can gain access to debt financing. It can go either to an investor, such as a bank, and get a loan, or it can issue a bond, which is a debt instrument that is traded on the secondary market. Both of the above instruments can be considered fixed-income investments. Debt & Credit capital markets are very large and involve a huge amount of different securities. We will, therefore, focus on the most common ones, starting with bonds.
Let’s imagine that Uncle Joe wants to invest in a new machine, as he wants to make a greater quantity of his infamous reusable bottles. He does not want to give up any more shares of his company, so he is advised to issue a bond. What he will issue will be within the corporate debt realm. The details of this bond are very simple: Uncle Joe will borrow $1,000 (face value of the bond) today from investors, in exchange with the promise to repay them 6% of the amount per year (coupon of the bond) for the next 5 years (maturity or duration of the bond), and then, pay back the $1,000 plus the coupon on year 5.
The term fixed income derives from the fact that no matter how Re-Bottle performs (unless it goes bankrupt) the debt holders will always receive a fixed amount of money (in this case the coupon payment of $60), and the investors’ income is “fixed”. Of course, there are many different kinds of debt and credit instruments tradeable in the secondary market. These can vary in how long their maturities are, they can have fixed and or variable interest rates, or there can even carry the optionality of converting them into equity. While many of these properties are a bit too complex for our current level, it is important to comprehend how “risk” is incorporated into fixed income.
Finally, it is very important to understand that the price of a bond on the secondary market is, as for stock, also constantly changing (even though usually less than for equity). These price changes though, will have no impact on the coupon and principal repayments of the bond but reflect the value that the promised future cash flows are considered to have at the moment of the trade (remember time value of money from Article 1?).
Credit Risk and Risk-Free Rates
Usually, higher interest rates on fixed income products entail that the company’s debt is riskier to invest in. This means that investors believe the likelihood of the firm not paying back its debt is higher and want to get compensated for that by earning a higher interest rate.
Governments of developed countries (such as the USA, the UK, Germany, etc…) also sell their own government bonds to investors. They use the money borrowed to make public investments (or at least are expected to do so). The risk of these countries not paying back their debt is usually extremely low, meaning that the interest rates these governments pay will also be very low. These interest rates are often denominated as the “risk-free” interest rate of an economy. Uncle Joe’s business, on the other hand, is seen as a risky investment as debt holders know Uncle Joe could make some managerial mistakes and not pay back his debt. The interest rate on the bonds he issues, will therefore always be greater than that of the government. The difference between the interest rate of Uncle Joe’s bond and the government’s bond is what you may have heard as “credit spread”.
If you look back at Re-Bottle’s balance sheet, you will see that in its assets is a voice called “Raw-Materials”. In fact, Re-Bottles requires a certain number of kilograms of aluminium every year to keep its operations going.
Aluminium, like many other precious metals, is known as a commodity. Commodities can actually be many kinds of things. Metals, livestock, energy resources (oil and gas are examples of these), cotton, corn, etc. The categories of commodities span through the whole of the supply chain and are a globalized kind of product.
Of course, it is harder to trade physical commodities compared to company shares or debt. In the end, ownership of a company is represented on a piece of (now digitized) paper. We cannot say the same thing about, for example, barrels of oil! What investors and traders can do instead, is invest in futures contracts following the prices of these commodities. These function through the same concept of future contracts on stocks: buying one is equivalent to locking a specific buying price on the underlying commodity in a specified amount of time in the future.
These kinds of contracts can be useful for corporations and were initially created on purpose for them. For example, Re-Bottle must ensure it receives a certain amount of aluminium every year, otherwise, the bottle manufacturing would stop, and this could be very costly for the firm! Imagine Uncle Joe goes to his aluminium supplier one year from now. He is very surprised to find out that aluminium’s price surged by 20% due to labour strikes. If he wants to continue the company’s operations, he has to buy it anyways.
Had he bought aluminium futures contracts beforehand, he would be certain of paying a maximum price of the one he had locked into through the future’s contract. In this example, we set this “locked” price at $2,100.
Foreign Exchange (FX)
Also, foreign exchange (the rates at which you can swap one currency for another) can be invested in and traded. The foreign exchange is de facto one of the most liquid markets in the world, meaning that usually, it is very relatively easy to find a buyer or seller for any specific currency.
The FX market is also very useful for businesses. Remember that investment that Uncle Joe wanted to make in the new machine? Well, we now find out that the machine that he is buying is constructed and sold by a large manufacturing operation in Germany. The sellers of the machine will only accept payment in Euros. This simply means that Uncle Joe will go to the foreign exchange and get the Euros he needs in exchange for the Dollars these Euros are worth.
To make this slightly more complex, Uncle Joe might know that he will have to pay in 1 year rather than now. He can, therefore, buy a futures (or forward) contract on the EURUSD exchange rate, locking in a specific price for this exchange in one year’s time.
As in equity, fixed income securities of all kinds can also include very complex derivative products. These can take the names of different 3 letter acronyms adding complexity to the market participants. For most of them, once a tiny detail changes, we suddenly have a new product, and yes, another new acronym. However, ordinary investors are safe to ignore this jargon and just focus on the main instruments they understand.