What are the Basics of Fixed Income Trading?

Fixed income trading is an investment field that deals with securities which return regular payments, or fixed income, to their investors. The most common type of fixed income security is a bond, which is issued by institutions to investors who receive periodic interest payments from the issuer. Investors will return more from fixed income trading if the interest rates offered for the bonds are high. It is important to note, however, that many issuers of bonds that yield high returns may not be able to keep up with their payment obligations and could possibly default.

Investors who put money into buying stocks run the risk of losing some or all of that money if the shares of stock they purchase fall in value. Since the stock market is based on the action of all of its investors, an individual investor in stocks can receive no assurance of regular returns on his capital. Fixed income trading, on the other hand, can generally guarantee that an investor will see some capital returned to him regardless of the volatility of the market.

The basic instrument that underpins most fixed income trading is the bond. An institution which issues a bond is essentially seeking loans from investors as a way to raise immediate capital. Investors who buy loans do so with the knowledge that the issuer is supposed to pay them interest payments at a rate determined at the start of the bond term. At the end of the bond term, the issuer generally returns the principal of the bond to the investor, which, added to the interest payments already received, gives the investor a net profit.

Unfortunately, there is no absolute guarantee that the issuer of the bond will repay the loan to the investor. In fixed income trading, if an institution offers a low interest rate, it generally means that the bond is relatively safe from default. Such bonds, also known as investment grade bonds, differ from bonds issued by institutions with low credit ratings. These junk bonds, as they are called in the finance industry, offer high interest rates to investors as a way to offset the relatively high possibility that a default on the bond may occur.

Investment grade bonds usually come from federal governments, local municipalities, or established corporations. Junk bonds are likelier be issued by corporations without proven track records or with poor credit histories. One basic strategy used in fixed income trading is portfolio diversification, which entails combining low-risk, low-paying investment grade bonds with riskier bonds that have high profit potential. This strategy allows for growth potential while lessening the overall risk levels.