The credit market is the largest in the world – much larger than the stock market. Debt investments range from investing in a country’s debt (US Treasuries, Mexico bonds), local government bonds or municipal bonds, to investing in residential or commercial mortgages (RMBS, CMBS) to corporate debt (corporate bonds, leveraged loans) and various other investments. Investing in credit products is essentially lending money to a borrower.
As opposed to stocks, these investments generally do not directly trade on exchanges and are mainly sold to large institutional investors in blocks of millions of dollars. As such, the bond market is much less liquid than the stock market. The way retail investors can get exposure to the asset class would be through ETFs or mutual funds.
In the financial services industry there are many terms that can be used to describe the same thing. Debt investments are also referred to as fixed income or credit. Bonds are the most common type of debt investments but others include loans and notes.
It would take more than a few textbooks to give a thorough review of the credit and fixed income market. The goal of this article is simply an introduction and overview of fixed income investments.
Why invest in bonds?
- Diversification – Bonds offer an easy way to diversify your portfolio.
- Income – Bonds pay interest. Whether it’s monthly, quarterly, semi-annually etc, one of the main reasons to invest in bonds is for the cash flow.
- Liability or Cash Flow matching – Investors can use bonds to match their cash outflow obligations with cash inflows from their fixed income investments.
What are some things to consider when investing in debt?
- Default Risk – What is the likelihood that this company or government will default? Default risk can be measured by a credit rating. For example USA is rated AAA (very low risk) while Argentina has a B rating (indicating high risk).
- Rate – What interest rate does this investment pay? Is it a fixed rate or a floating rate? Typically, investments that pay a higher rate indicate higher risk.
- Term – How long until they pay me my money back? This can range from 1 day to 30 years or longer. The longer the term the higher you would expect the interest rate to be since they are keeping your money tied up for longer. With a longer term comes more risk since the probability of default increases.
- Liquidity Risk – Other than US Treasuries, the bond market is not very liquid meaning the bid ask spread can be very wide at times. As a result, if you need to sell a large amount in a hurry you may get crushed on the price.
- Interest Rate Risk- Interest rates play a big part when it comes to debt investments. As interest rates go up, bond prices go down. As interest rates go down, bond prices go up.
Corporate Debt
When companies go bankrupt the debt holders get paid before the stock holders. Depending on the specific company’s capital structure there can be many different seniority levels that determine the order in which investors get paid. Understanding where your investment ranks in seniority is critical when investing in debt. To get a sense of a company’s capital structure see the figure below.
Securitizations / Structured Finance Products
Securitization is the process of taking a pool of assets and packaging them into an investment product (an investment security). Investors can gain exposure to a variety of sources of cash flow at different risk levels through structured products. Examples of the underlying assets include; student loans, residential mortgages, commercial mortgages, business loans, auto loans and leases, credit card receivables, royalties, etc. Securitization makes these asset classes more accessible to investors.
I think it would be safe to say that fixed income products can be a bit more complex than equity investments. There are topics such as duration and convexity not to mention yield curve changes that make this asset class very interesting.
