Fixed Income is an Appropriate Term

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Phineas J. Whoopee
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Fixed Income is an Appropriate Term

Post by Phineas J. Whoopee » Tue Feb 13, 2018 8:36 pm

It's become fashionable around here to say fixed income is neither fixed nor income.

The expression refers to coupons of plain vanilla bonds (no weird terms and conditions, T&C).

Under that constraint, the coupons are fixed, and they are income.

We can argue over whether a bond fund should be described that way, or for that matter a personally-managed rolling bond ladder (which works out the same), but the term fixed income has good reasons behind it, that reflect the underlying structure of bonds, which are contracts for the exchange of money over time.

Should anybody mistake capital for income, let them post in this thread so we can talk about it.

PJW

Beensabu
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Re: Fixed Income is an Appropriate Term

Post by Beensabu » Wed Feb 14, 2018 1:20 am

I would like to learn from you, if you're willing and I wasn't too irritating last time.

My understanding is this:

An individual bond annually pays out the coupon rate on the face/par value until it matures, and then you get the original amount back. So a 10-year bond of $10k with a 2% coupon pays $200/year for 10 years and then you get your $10k back, as long as the bond issuer doesn't default. If 10-year bonds with higher coupon rates come along while you are holding that bond, then the value of the bond should you attempt to sell it will be less than the face value, but you will continue to receive the fixed income of $200/year while you hold it. Likewise, if 10-year bonds with lower coupon rates come along while you are holding that bond, then the value of the bond should you attempt to sell it will be more than the face value, but you will continue to receive the fixed income of $200/year while you hold it.

A bond fund holds multiple bonds, from various issuers, some obtained at issuance and some bought from previous holders (at either a discount or a premium), with varying coupon rates and varying maturities, for varying durations. If the NAV of the bond fund goes up, the yield goes down. Likewise, if the NAV of the bond fund goes down, the yield goes up. If the NAV and yield move at the same rate, then the income being received stays fixed.

Does that actually happen? Do the yield and NAV move at the same rate? Or is it more "variable range of" (rather than "fixed") income when it comes to a bond fund?

This is where I get confused.

The NAV of the bond fund is tied to the perceived value of the bonds it holds? The yield of the bond fund is tied to the average coupon rates of the bonds it holds and the bond fund's NAV? Or...
"The only thing that makes life possible is permanent, intolerable uncertainty; not knowing what comes next."

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Phineas J. Whoopee
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Re: Fixed Income is an Appropriate Term

Post by Phineas J. Whoopee » Wed Feb 14, 2018 1:08 pm

Hi Beensabu.

I intend to discuss your questions, which are good ones and probably widely shared. You display a nice level of knowledge, and there's more I can help clarify.

For those reasons I want to take care in drafting my response, but I don't think I have time today. I'll get back to you, probably tomorrow. OK?

PJW

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Re: Fixed Income is an Appropriate Term

Post by Beensabu » Wed Feb 14, 2018 11:26 pm

Thank you for taking the time and expending the effort to educate others, PJW. I look forward to reading your response whenever you are able to get to it.
"The only thing that makes life possible is permanent, intolerable uncertainty; not knowing what comes next."

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Phineas J. Whoopee
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Re: Fixed Income is an Appropriate Term

Post by Phineas J. Whoopee » Sun Feb 18, 2018 1:55 pm

Hi Beensabu. I'm sorry it took me longer than I said to write a reply, even though the post is shorter than I thought it would be. Due to the recent terrible news event I found myself with the time but without the heart to draft a technical reply about bonds until today.
Beensabu wrote:
Wed Feb 14, 2018 1:20 am
I would like to learn from you, if you're willing and I wasn't too irritating last time.

My understanding is this:

An individual bond annually pays out the coupon rate on the face/par value until it matures, and then you get the original amount back. So a 10-year bond of $10k with a 2% coupon pays $200/year for 10 years and then you get your $10k back, as long as the bond issuer doesn't default. If 10-year bonds with higher coupon rates come along while you are holding that bond, then the value of the bond should you attempt to sell it will be less than the face value, but you will continue to receive the fixed income of $200/year while you hold it. Likewise, if 10-year bonds with lower coupon rates come along while you are holding that bond, then the value of the bond should you attempt to sell it will be more than the face value, but you will continue to receive the fixed income of $200/year while you hold it.
Yes.
Beensabu wrote:
Wed Feb 14, 2018 1:20 am
A bond fund holds multiple bonds, from various issuers, some obtained at issuance and some bought from previous holders (at either a discount or a premium), with varying coupon rates and varying maturities, for varying durations. If the NAV of the bond fund goes up, the yield goes down. Likewise, if the NAV of the bond fund goes down, the yield goes up. If the NAV and yield move at the same rate, then the income being received stays fixed.
Your word if is not quite completely correct. I'll explain below.
Beensabu wrote:
Wed Feb 14, 2018 1:20 am
Does that actually happen? Do the yield and NAV move at the same rate? Or is it more "variable range of" (rather than "fixed") income when it comes to a bond fund?

This is where I get confused.

The NAV of the bond fund is tied to the perceived value of the bonds it holds? The yield of the bond fund is tied to the average coupon rates of the bonds it holds and the bond fund's NAV? Or...
I think there is a misunderstanding, a widely-shared one so nobody should feel bad, of what the technical finance term yield means in this context.

Yield, which if not otherwise specified normally means Yield to Maturity, YTM, is a mathematical calculation that depends on:

The coupon cash and its timing;

The repaid face value and its timing;

The present market value of the bond; and

An estimate of the yield at which the coupon payments can be reinvested as they arrive (normally the YTM of the bond when it was issued on the primary market).

Because the fourth can only be an estimate there's an associated risk called reinvestment risk. Unlike the way it is often used on this forum, reinvestment risk does not mean what you can do with the original face value when it's finally paid back. It means what yield(s) you will be able to get on the coupon payments if you invest them, rather than spend them, over time and up until the bond's maturity date.

Coupon is not the same as YTM. It's just one of the inputs to the formula, but for simple-type bonds it is a fixed amount of money paid on predetermined dates.

YTM uses the present market value of the bond, or of each one in a collection of bonds (like an individual could hold, or a mutual fund normally does hold) as an input, so it immediately adapts as a percentage when the price changes. It does not imply the dollar amount of the coupon(s) has changed.

Does that help? If not please say so and I'll try again.

PJW

Beensabu
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Re: Fixed Income is an Appropriate Term

Post by Beensabu » Sun Feb 18, 2018 4:04 pm

Hi PJW,

Yes, that does help very much. Thank you!

I'm a bit embarrassed I didn't dig into more available info on the web first, but your post and the links you provided serve as a great jumping off point for increasing understanding. I found the info on these additional pages helpful as well: Price Value of a Basis Point and Modified Duration.

I appreciate your explanation and pointing.

~Beensabu
"The only thing that makes life possible is permanent, intolerable uncertainty; not knowing what comes next."

ralph124cf
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Re: Fixed Income is an Appropriate Term

Post by ralph124cf » Sun Feb 18, 2018 9:23 pm

Hi PJW.

I understand your explanation of YTM, however the sticking point seems to be in determining market value.

This is easy for frequently traded issues such as T-Bonds and Notes, but for thinly traded, lower credit quality corporates and municipals it seems to present a problem. There frequently seems to be quite a wide spread between bid and asked, and many issues do not trade every day, so how is the market value determined for these thinly traded issues?

Ralph

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Re: Fixed Income is an Appropriate Term

Post by nisiprius » Sun Feb 18, 2018 9:28 pm

The income from a bond is a heck of a lot more "fixed" than the income from a dividend-paying stock.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

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Phineas J. Whoopee
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Re: Fixed Income is an Appropriate Term

Post by Phineas J. Whoopee » Mon Feb 19, 2018 2:35 pm

ralph124cf wrote:
Sun Feb 18, 2018 9:23 pm
Hi PJW.

I understand your explanation of YTM, however the sticking point seems to be in determining market value.

This is easy for frequently traded issues such as T-Bonds and Notes, but for thinly traded, lower credit quality corporates and municipals it seems to present a problem. There frequently seems to be quite a wide spread between bid and asked, and many issues do not trade every day, so how is the market value determined for these thinly traded issues?

Ralph
Hi Ralph. What you say is true about illiquid assets in general, including thinly-traded bonds. With uncertainties about market value come uncertainties about a bond's Yield to Maturity, YTM. The numerical result of a formula is no more precise than the least precise input. That's about all there is to it.

During last decade's financial crisis there was a serious systemic problem in that the holders of quite a lot of complex securities, for example Structured Investment Vehicles, weren't willing to sell them at a price anybody would pay, and if they marked them to market at the highest bid they would financially fail due to not having enough capital.

Whatever one's feelings about fairness and accounting, that would have made the situation even worse.

PJW

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