What Is Fixed Income in Investment Banking?

Fixed income is a foundational element in finance, representing a class of investments characterized by predictable returns. Within investment banking, fixed income plays a role encompassing the issuance, trading, and analysis of these securities. It serves as a mechanism for governments, corporations, and other entities to raise capital, while offering investors a steady stream of income.

Understanding Fixed Income

Fixed income refers to investments that provide regular, predetermined payments to investors, along with the return of the original principal amount at a specified maturity date. These investments are essentially loans made by an investor to an issuer. The “fixed” aspect derives from the scheduled interest payments, known as coupon payments, received by the investor.

A core concept in fixed income is yield, which represents the total return an investor earns on a bond. Yield considers interest payments and any capital gains or losses. Bond prices and their yields move inversely; when bond prices rise, yields fall, and vice versa.

Interest rate risk is a consideration for fixed income investments. This risk stems from an asset’s value declining due to changes in prevailing interest rates. When interest rates rise, newly issued bonds offer higher returns, making existing bonds with lower yields less attractive, which can cause their market prices to fall. Conversely, falling interest rates lead to an increase in the value of existing bonds.

Key Fixed Income Products

Fixed income markets encompass a variety of securities. Government bonds, often called Treasuries, are debt instruments issued by federal, state, and local governments to finance public spending. These are considered low-risk investments due to government backing. U.S. Treasuries include Treasury bills (maturing in less than one year), Treasury notes (maturing in 2-10 years), and Treasury bonds (maturing in 20-30 years), with interest typically paid semi-annually.

Corporate bonds are debt securities issued by companies to fund operations, expansion, or mergers and acquisitions. These bonds offer higher yields than government bonds to compensate investors for increased credit risk, the possibility of the issuer defaulting. Interest earned on corporate bonds is subject to federal and state income taxes. Corporate bonds can have maturities ranging from short-term (up to five years) to long-term (more than 12 years).

Municipal bonds are issued by state and local governments to finance public projects. Interest income from municipal bonds is often exempt from federal income tax and, in some cases, state and local taxes for residents within the issuing jurisdiction. This tax advantage can make them attractive to investors in higher tax brackets, even if their yields are lower than corporate bonds.

Mortgage-Backed Securities (MBS) are investment products representing claims to cash flows from pools of mortgage loans. These securities are created when financial institutions, or government-sponsored entities like Fannie Mae and Freddie Mac, bundle individual mortgages and sell shares to investors. Investors in MBS receive periodic payments derived from the principal and interest payments made by underlying mortgage holders. MBS carry prepayment risk, where homeowners might pay off their mortgages early, affecting expected cash flows.

Asset-Backed Securities (ABS) are similar to MBS but are collateralized by a broader range of income-generating assets beyond mortgages, such as auto loans, credit card receivables, student loans, and leases. The process of pooling these illiquid assets and transforming them into tradable securities is known as securitization. ABS allow issuers to raise capital by converting future cash flows from these assets into immediate funds, providing investors with a steady stream of interest payments.

The Role of Investment Banks in Fixed Income

Investment banks play a role in the fixed income market, facilitating the flow of capital between issuers and investors.

Origination/Underwriting

Investment banks assist governments and corporations in issuing new fixed income securities through origination or underwriting. The bank advises the issuer on the structure, pricing, and timing of the bond offering. The bank often purchases the entire bond issue from the issuer at a discount and resells it to investors, assuming the risk of selling the securities. This underwriting fee, also known as the underwriting spread, compensates the investment bank for its services and the risk undertaken.

Sales & Trading

Investment banks operate sales and trading desks that are fundamental to the liquidity of fixed income markets. Sales professionals interact with institutional clients to understand their investment needs and recommend suitable fixed income products. Traders execute these transactions, buying and selling securities to fulfill client orders or manage the firm’s own inventory. This involves quoting bid (buy) and ask (sell) prices, and managing the firm’s exposure to market fluctuations.

The trading desk acts as a market maker, providing continuous liquidity by being ready to buy or sell securities. This ensures investors can readily purchase or dispose of their fixed income holdings. Traders also engage in proprietary trading, using the firm’s capital to take positions based on interest rate movements or credit trends. The sales and trading function generates revenue for the bank through commissions, mark-ups on trades, and profits from proprietary positions.

Research

Investment banks provide research and analysis on fixed income markets and specific securities to their clients. Fixed income research teams analyze economic data, interest rate forecasts, credit trends, and issuer-specific financial health. This analysis helps clients make informed investment decisions by providing insights into market opportunities and risks.

Research reports include assessments of bond creditworthiness, yield curve analysis, and sector-specific outlooks. This information is distributed to institutional investors, aiding them in portfolio construction and risk management. The research function supports sales and trading efforts by offering valuable content and expertise that strengthens client relationships.

Fixed Income Markets and Participants

Fixed income securities are traded in two environments: the primary market and the secondary market. The primary market is where new bonds are initially issued by governments, corporations, and other entities to raise capital directly from investors. This initial sale often occurs through an underwriting process managed by investment banks.

Once issued, bonds are traded among investors in the secondary market. This market provides liquidity, allowing investors to buy or sell existing bonds before maturity dates. Most fixed income trading, particularly for corporate and municipal bonds, occurs over-the-counter (OTC) rather than on centralized exchanges. In an OTC market, transactions are conducted directly between two parties or through a network of dealers.

Beyond investment banks, several participants shape the fixed income ecosystem. Institutional investors, such as pension funds, insurance companies, mutual funds, and hedge funds, are major buyers and holders of fixed income securities. These entities invest in bonds to meet long-term liabilities, generate stable income, or diversify their portfolios. Central banks influence fixed income markets through monetary policy decisions, such as setting interest rates and engaging in open market operations to manage liquidity and economic growth. Large corporations participate as both issuers of bonds to raise capital and as investors, managing their cash reserves.