Fixed income refers to any type of investment under which the borrower or issuer 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. Fixed-income securities (more commonly known as bonds) 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. Bonds carry a level of legal protections for investors that equity securities do not: in the event of a bankruptcy, bond holders would be repaid after liquidation of assets, whereas shareholders with stock often receive nothing.
41-631: For a company to grow its business, it often must raise money – for example, to finance an acquisition; buy equipment or land, or invest in new product development. The terms on which investors will finance the company will depend on the risk profile of the company. The company can give up equity by issuing stock or can promise to pay regular interest and repay the principal on the loan (bonds or bank loans). Fixed-income securities also trade differently than equities. Whereas equities, such as common stock, trade on exchanges or other established trading venues, many fixed-income securities trade over-the-counter on
82-407: A capital gain . Equity holders typically receive voting rights, meaning that they can vote on candidates for the board of directors and, if their holding is large enough, influence management decisions. Investors in a newly established firm must contribute an initial amount of capital to it so that it can begin to transact business. This contributed amount represents the investors' equity interest in
123-451: A financial statement known as the balance sheet (or statement of net position) which shows the total assets, the specific equity balances, and the total liabilities and equity (or deficit). Various types of equity can appear on a balance sheet, depending on the form and purpose of the business entity. Preferred stock , share capital (or capital stock) and capital surplus (or additional paid-in capital) reflect original contributions to
164-522: A 5 yr TIPS), the adjusted principal of the fixed income would rise from 100 to 103.88 and then the real yield would be applied to the adjusted principal, meaning 103.88 x 1.0261, which equals 106.5913; giving a total return of 6.5913%. TIPS moderately outperform conventional US Treasuries, which yielded just 5.05% for a one-year bill on October 19, 2006. Fixed income derivatives include interest rate derivatives and credit derivatives . Often inflation derivatives are also included into this definition. There
205-417: A doctor then says there is a test for said cancer that is approximately 80% reliable , and that the test provides a positive result for 100% of people who have cancer, but it also results in a 'false positive' for 20% of people - who do not have cancer . Testing positive may therefore lead people to believe that it is 80% likely that they have cancer. Devlin explains that the odds are instead less than 5%. What
246-670: A fixed income ( defined benefit as contrasted with defined contribution ). When pensioners or retirees are dependent on their pension (whether a private-sector one , a public-sector one , or both) as their dominant source of income, the term "fixed income" can also imply that they have relatively limited discretionary income or have little financial freedom to make large or discretionary expenditures. Governments issue government bonds in their own currency and sovereign bonds in foreign currencies. State and local governments issue municipal bonds to finance projects or other major spending initiatives. Debt issued by government-backed agencies
287-426: A liability) even if the firm has a shareholder deficit, because the deficit is not the owners' responsibility. An alternate approach, exemplified by the " Merton model ", values stock-equity as a call option on the value of the whole company (including the liabilities), struck at the nominal value of the liabilities. The analogy with options arises in that limited liability protects equity investors: (i) where
328-405: A more complicated debt structure than a single asset. While some liabilities may be secured by specific assets of the business, others may be guaranteed by the assets of the entire business. If the business becomes bankrupt , it can be required to raise money by selling assets. Yet the equity of the business, like the equity of an asset, approximately measures the amount of the assets that belongs to
369-430: A principal basis. The term "fixed" in "fixed income" refers to both the schedule of obligatory payments and the amount. "Fixed income securities" can be distinguished from inflation-indexed bonds , variable-interest rate notes, and the like. If an issuer misses a payment on fixed income security, the issuer is in default , and depending on the relevant law and the structure of the security, the payees may be able to force
410-425: A risk that the owner will default with a deficit, while other assets are financed with full-recourse loans that make the borrower responsible for any deficit. The equity of an asset can be used to secure additional liabilities. Common examples include home equity loans and home equity lines of credit . These increase the total liabilities attached to the asset and decrease the owner's equity. A business entity has
451-549: A set schedule. When liabilities attached to an asset exceed its value, the difference is called a deficit and the asset is informally said to be "underwater" or "upside-down". In government finance or other non-profit settings, equity is known as "net position" or "net assets". The term "equity" describes this type of ownership in English because it was regulated through the system of equity law that developed in England during
SECTION 10
#1732781104084492-524: A specific price index. The most common examples are US Treasury Inflation Protected Securities (TIPS) and UK Index Linked Gilts . The interest and principal repayments under this type of bond are adjusted in line with a Consumer Price Index (in the US this is the CPI-U for urban consumers). This means that these bonds are guaranteed to outperform the inflation rate (unless (a) the market price has increased so that
533-759: A variety of factors, such as current short-term interest rates, e.g. base rates set by central banks such as the US Federal Reserve , the Bank of England in the UK, and the Euro Zone ECB . If the coupon on the bond is lower than the yield, then its price will be below the par value, and vice versa. In buying a bond, one is buying a set of cash flows, which are discounted according to the buyer's perception of how interest and exchange rates will move over its life. Supply and demand affect prices, especially in
574-462: Is a wide range of fixed income derivative products: options , swaps , futures contracts as well as forward contracts . The most widely traded kinds are: Fixed income securities have risks that may include but are not limited to the following, many of which are synonymous, mutually exclusive, or related: Ownership equity In finance, equity is an ownership interest in property that may be offset by debts or other liabilities . Equity
615-460: Is called an agency bond . Companies can issue a corporate bond or obtain money from a bank through a corporate loan. Preferred stocks share some of the characteristics of fixed interest bonds. Securitized bank lending (e.g. credit card debt, car loans or mortgages) can be structured into other types of fixed income products such as ABS – asset-backed securities which can be traded over-the-counter just like corporate and government bonds. Some of
656-423: Is given by Bayes' rule . In the sciences , including medicine , the base rate is critical for comparison. In medicine a treatment's effectiveness is clear when the base rate is available. For example, if the control group , using no treatment at all, had their own base rate of 1/20 recoveries within 1 day and a treatment had a 1/100 base rate of recovery within 1 day, we see that the treatment actively decreases
697-461: Is measured for accounting purposes by subtracting liabilities from the value of the assets owned. For example, if someone owns a car worth $ 24,000 and owes $ 10,000 on the loan used to buy the car, the difference of $ 14,000 is equity. Equity can apply to a single asset, such as a car or house, or to an entire business. A business that needs to start up or expand its operations can sell its equity in order to raise cash that does not have to be repaid on
738-409: Is missing from these statistics is the relevant base rate information. The doctor should be asked, "Out of the number of people who test positive (base rate group), how many have cancer?" In assessing the probability that a given individual is a member of a particular class, information other than the base rate needs to be accounted for, especially featural evidence. For example, when a person wearing
779-424: Is not uncommon for companies to issue more than one class of stock, with each class having its own liquidation priority or voting rights. This complicates analysis for both stock valuation and accounting. A company's shareholder equity balance does not determine the price at which investors can sell its stock. Other relevant factors include the prospects and risks of its business, its access to necessary credit, and
820-519: The Late Middle Ages to meet the growing demands of commercial activity. While the older common law courts dealt with questions of property title , equity courts dealt with contractual interests in property. The same asset could have an owner in equity, who held the contractual interest, and a separate owner at law, who held the title indefinitely or until the contract was fulfilled. Contract disputes were examined with consideration of whether
861-478: The "real" yield is negative, which is the case in 2012 for many such UK bonds, or (b) the government or other issuer defaults on the bond). This allows investors of all types to preserve the purchasing power of their money even at times of high inflation. For example, assuming 3.88% inflation over the course of one year (just about the 56 year average inflation rate, through most of 2006), and a real yield of 2.61% (the fixed US Treasury real yield on October 19, 2006, for
SECTION 20
#1732781104084902-463: The appropriate threshold for a positive test result. Many psychological studies have examined a phenomenon called base-rate neglect or base rate fallacy , in which category base rates are not integrated with presented evidence in a normative manner, although not all evidence is consistent regarding how common this fallacy is. Mathematician Keith Devlin illustrates the risks as a hypothetical type of cancer that afflicts 1% of all people. Suppose
943-416: The balance sheet. Another financial statement, the statement of changes in equity , details the changes in these equity accounts from one accounting period to the next. Several events can produce changes in a firm's equity. Equity investing is the business of purchasing stock in companies, either directly or from another investor, on the expectation that the stock will earn dividends or can be resold with
984-476: The bond matures or is refinanced, the person will have their money returned to them. The major investors in fixed-income securities are institutional investors , such as pension plans, mutual funds, hedge funds, sovereign wealth funds, endowments, insurance companies and others. The main number which is used to assess the value of the bond is the gross redemption yield . This is defined such that if all future interest and principal repayments are discounted back to
1025-580: The business from its investors or organizers. Treasury stock appears as a contra-equity balance (an offset to equity) that reflects the amount that the business has paid to repurchase stock from shareholders. Retained earnings (or accumulated deficit) is the running total of the business's net income and losses, excluding any dividends . In the United Kingdom and other countries that use its accounting methods, equity includes various reserve accounts that are used for particular reconciliations of
1066-412: The buyer's partial ownership. This may be different from the total amount that the buyer has paid on the loan, which includes interest expense and does not consider any change in the asset's value. When an asset has a deficit instead of equity, the terms of the loan determine whether the lender can recover it from the borrower. Houses are normally financed with non-recourse loans, in which the lender assumes
1107-488: The case of market participants who are constrained in the investments they make. Insurance companies and pension funds usually have long term liabilities that they wish to hedge, which requires low risk, predictable cash flows, such as long dated government bonds. Some fixed-income securities, such as mortgage-backed securities, have unique characteristics, such as prepayments, which impact their pricing. There are also inflation-indexed bonds —fixed-income securities linked to
1148-411: The class of probabilities unconditional on "featural evidence" ( likelihoods ). It is the proportion of individuals in a population who have a certain characteristic or trait. For example, if 1% of the population were medical professionals, and remaining 99% were not medical professionals, then the base rate of medical professionals is 1%. The method for integrating base rates and featural evidence
1189-474: The difficulty of locating a buyer. According to the theory of intrinsic value , it is profitable to buy stock in a company when it is priced below the present value of the portion of its equity and future earnings that are payable to stockholders. Advocates of this method have included Benjamin Graham , Philip Fisher and Warren Buffett . An equity investment will never have a negative market value (i.e. become
1230-401: The disease status. The base rate is also important in decision-making , particularly in situations where the cost of false positives and false negatives are different. For example, in medical testing, a false negative (failing to diagnose a disease) could be much more costly than a false positive (incorrectly diagnosing a disease). In such cases, the base rate can help inform decisions about
1271-423: The firm. In return, they receive shares of the company's stock. Under the model of a private limited company , the firm may keep contributed capital as long as it remains in business. If it liquidates, whether through a decision of the owners or through a bankruptcy process, the owners have a residual claim on the firm's eventual equity. If the equity is negative (a deficit) then the unpaid creditors bear loss and
Fixed income - Misplaced Pages Continue
1312-446: The issuer into bankruptcy . In contrast, if a company misses a quarterly dividend to stock (non-fixed-income) shareholders, there is no violation of any payment covenant and no default. The term "fixed income" is also applied to a person's income that does not vary materially over time. This can include income derived from any combination of (1) fixed-income investments such as bonds and preferred stocks or (2) pensions that guarantee
1353-610: The owners of the business. In financial accounting , the equity is derived by subtracting its liabilities from its assets. For a business as a whole, this value is sometimes referred to as total equity , to distinguish it from the equity of a single asset. The fundamental accounting equation requires that the total of liabilities and equity is equal to the total of all assets at the close of each accounting period. To satisfy this requirement, all events that affect total assets and total liabilities unequally must eventually be reported as changes in equity. Businesses summarize their equity in
1394-540: The owners' claim is void. Under limited liability , where the financial liability is limited to a fixed sum, owners are not required to pay the firm's debts themselves so long as the firm's books are in order and it has not involved the owners in fraud. When the owners of a firm are shareholders , their interest is called shareholders' equity. It is the difference between a company's assets and liabilities, and can be negative. If all shareholders are in one class, they share equally in ownership equity from all perspectives. It
1435-405: The present, at an interest rate equal to the gross redemption yield (gross means pre-tax), then the discounted value is equal to the current market price of the bond (or the initial issue price if the bond is just being launched). Fixed income investments such as bonds and loans are generally priced as a credit spread above a low-risk reference rate, such as LIBOR or U.S. or German Government Bonds of
1476-420: The prevalence of a disease in a population. The base rate would be the proportion of individuals in the population who have the disease. If we observe a positive test result for a particular individual, we can use Bayesian analysis to update our belief about the probability that the individual has the disease. The updated probability would be a combination of the base rate and the likelihood of the test result given
1517-515: The recovery. The base rate is an important concept in statistical inference , particularly in Bayesian statistics . In Bayesian analysis, the base rate is combined with the observed data to update our belief about the probability of the characteristic or trait of interest. The updated probability is known as the posterior probability and is denoted as P(A|B), where B represents the observed data. For example, suppose we are interested in estimating
1558-446: The same duration. For example, if a 30-year mortgage denominated in US dollars has a gross redemption yield of 5% per annum and 30 year US Treasury Bonds have a gross redemption yield of 3% per annum (referred to as the risk free yield), the credit spread is 2% per annum (sometimes quoted as 200 basis points). The credit spread reflects the risk of default. Risk free interest rates are determined by market forces and vary over time, based on
1599-437: The terminology used in connection with these investments is: 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 gratuity, but not consume principal. This person can buy a bond with their money and use the coupon payment (the interest) as that regular dependable payment. When
1640-417: The terms and administration of the contract were fair—that is, equitable. Any asset that is purchased through a secured loan is said to have equity. While the loan remains unpaid, the buyer does not fully own the asset. The lender has the right to repossess it if the buyer defaults , but only to recover the unpaid loan balance. The equity balance—the asset's market value reduced by the loan balance—measures
1681-400: The value of the firm is less than the value of the outstanding debt, shareholders may, and therefore would, choose not to repay the firm's debt; (ii) where firm value is greater than debt value, the shareholders would choose to repay—i.e. exercise their option—and not to liquidate. Base rate In probability and statistics , the base rate (also known as prior probabilities ) is