Equity and fixed income

In simple terms

There are two basic ways to invest money in a business or government:

• Equity: you become a part-owner. You share in profits through dividends and a rising share price, and in losses through a falling one. There is no promised return.
• Fixed income: you become a lender. You receive agreed interest and get your money back at a set date, as long as the borrower pays. Bonds, debentures, bank deposits and debt mutual funds are all forms of fixed income.

Fixed income is usually steadier than equity, which is why it plays a stabilising role in portfolios. But "fixed" refers to the payments promised, not to a guarantee that you cannot lose money.

Comparing the two

Credit risk

Credit risk is the risk that a borrower fails to pay interest or repay the loan in full. It is low for government bonds in their own currency and higher for companies, especially those with weak finances. Credit ratings from rating agencies estimate this risk, though ratings can be wrong or change suddenly.

Higher-yielding bonds usually pay more because their credit risk is higher. A bond offering far more than similar bonds is telling you something about its risk.

Interest-rate risk

Interest-rate risk is the risk that a bond's price falls because interest rates rise.

The longer the time until a bond matures, the more its price moves when rates change. Short-term bonds and deposits are less exposed.

Deposits, bonds and debt funds

• Bank deposits pay agreed interest and are protected up to a limit by deposit insurance, as the saving and inflation lesson explains. Their value does not fluctuate, but breaking them early can cost a penalty.
• Individual bonds can be held to maturity, but their market price changes in the meantime, and selling early may mean a loss or gain.
• Debt mutual funds hold many bonds and report a value every day. That value moves with interest rates and credit events, so a debt fund can show losses even when no bond in it has defaulted. Funds holding lower-rated bonds can lose more if issuers fail.

Inflation risk

Fixed payments lose buying power when inflation is high. A deposit paying 6% when prices rise 6% earns nothing in real terms, as the real returns lesson explains. Over long periods, this is a major limitation of fixed income for long-term goals.

The role of fixed income in a portfolio

• Stability: it usually falls less than shares in market crashes, cushioning the portfolio.
• Near-term money: it suits goals a few years away, as the goals lesson explains.
• Rebalancing: after shares fall, money can be moved from fixed income into shares at lower prices, as the rebalancing lesson explains.
• Income: regular interest suits those who need cash flow.

Why it matters

Many people assume bonds, deposits and debt funds are completely safe, and are surprised when a debt fund falls or an issuer defaults. Understanding credit and interest-rate risk shows where fixed income fits, steadying a portfolio and funding near-term goals, and what can still go wrong.

Limitations

This lesson describes how fixed income behaves in general. Specific products differ in their rules, tax treatment and protections, which are set by regulators and the law and can change. Ratings, interest rates and inflation are uncertain.

Common mistakes

• Assuming fixed income cannot lose money.
• Chasing the highest yield without checking credit risk.
• Ignoring interest-rate risk in long-term bonds and funds.
• Ignoring inflation when holding fixed income for long goals.

Try it yourself

1. Find the yield on a short-term and a long-term government bond on the Reserve Bank of India's website.
2. Look up a debt fund's factsheet and note its average maturity and the credit ratings of its holdings.
3. Using the method in the example, estimate how much a 10-year bond paying 7% would fall if similar bonds paid 8.5%.
4. Write down which of your goals fixed income suits, and why.