Our definition of income assets is generally broader than just fixed income securities such as bonds, strips, mortgage-backed securities, etc. Following our broader definition we could also include preferred shares, high yielding common stocks (i.e. utility stocks) and in some cases, even income trusts. Of course the latter is a hybrid security, that for most is defined as an equity asset.

This week we keep to our narrow focus and look at fixed income securities, what makes them tick, and where they fit inside a portfolio. We characterize a fixed income asset as a security with a defined life span. We know for example, that the Government of Canada 9% bonds due March 1st, 2011, will definitely mature on that date and cease to exist thereafter.

We also look for securities whose income stream is consistent, and fixed. Those Government of Canada bonds we just looked will deliver semi-annual interest payments at a fixed rate of 9% per year. Fixed income assets also trade, for the most part, on the basis of their yield. The price of a fixed-income security is interest rate sensitive, typically rising when interest rates are falling and vice versa.

These characteristics matter because the interest-rate sensitivity of these securities is their key contribution to portfolio diversification.

With that in mind, let’s understand the properties related to fixed income assets. We know for example, that the price of a bond is inversely related to the direction of the change in interest rates. When rates rise, bond prices fall, when interest rates fall, bond prices rise.

Bond prices change because the bonds’ coupon and term to maturity are fixed. Because bond returns must maintain some kind of relationship to what current interest rates are, and because the coupon rate and term to maturity don’t change, something has to give. That something is its price.

To make the point, let’s suppose that one year interest rates are at 3%. Given that, investors would be willing to pay $100 for a 3% coupon bond, maturing in one year. An investor in that bond would be getting a 3% return from the fixed coupon payments over the next year, which is fair enough, considering interest rates are 3%.

Now suppose interest rates rise to 4%. That 3% bond must now offer investors a 4% return, or no investor would buy it. More to the point, investors who already own it would not be able to sell it. At least not for $100.

However, if the seller dropped his price to $99, other investors would now be willing to buy it. Why? Because if the bond were purchased at $99, and held to maturity, the investor will receive $100 a year later, for a $1 gain plus the 3% in interest income. The $1 capital gain plus the interest income boosts the bond’s total return to 4%. That total return (any capital appreciation plus interest income) is referred to as the bonds yield to maturity.

The same is true if interest rates fell to 2%. A bond paying 3% is relatively attractive in this environment. The seller could raise his price to $101, and buyers would still be interested. By upping the price for a bond that pays a 3% coupon, the buyer would net 2% over the next year.

Moving to property two; the lower the coupon rate on the bond, the more that bond’s price rises and falls. The coupon rate on a bond is the contractual interest obligation of the issuer to pay the bondholder a set dollar amount on various predetermined dates, usually twice a year. The amount of the payment depends on the coupon rate of the bond, expressed as a percentage of the face value of the bond. For example, a 6% bond would pay the holder of the bond $6 per year for every $100 face value of the bond held. Because most bonds pay twice per year, this investor would actually get two payments of $3 each, spaced six months apart.

Coupon rates come in all sizes, from less than 2% to more than 14%, and every increment in between. The level of the coupon rate determines, in part, how much a bond goes up or down in price when interest rates change. If a bond has a high coupon rate, say 12%, interest rate changes won’t affect the price of this bond very much. The same rate change would affect the price of a 4% bond a lot more.

That is important information to a bond manager. If the manager felt that interest rates were heading for a long, sustained series of decreases, as we saw in 2001, that manager might switch his bond holdings into lower coupon bonds to increase his capital gains. In the current market where rates have been rising, the better performing bond managers have been holding higher coupon bonds and probably shorter maturities, which leads to our next property.

Property three; the longer the term of the bond, the more that bond’s price rises and falls. For the same change in interest rates, longer-term bonds change more in price than shorter-term bonds. And the longer the term, the more the price moves. Much like the swings on a teeter-totter. The longer the teeter-totter the more violent the swing from top to bottom.

The explanation of why longer-term bonds move more in price is a bit more involved. But let’s try it this way: The longer the investor has to wait for principal to be repaid, the more things can happen to impair the receipt of that money. Recession, war - who knows what - may happen in the next thirty years. The longer the term, the less the predictability and the greater the price volatility. That’s why longer term bonds typically offer higher yields.

Property four: credit quality affects price. Bonds come in a wide variety of credit qualities and changes in the markets view about the bond’s quality can have a significant effect on its price. Remember how a ratings review impacted General Motors Acceptance Corporation (GMAC) and Ford Motor Credit.

Government of Canada bond issues are rated at the top of the food chain, because the federal government always has an unquestioned ability to pay. In theory, the government could place a 100% tax on the bond, and bingo, it’s paid off! As you move down the ratings, you encounter provincial government issues, high-grade or investment grade corporate bonds, non-investment grade corporate bonds, and then higher risk bonds called high-yield or “junk” bonds.

Basically then, fixed-income securities prices are affected by four major influences, current interest rates, coupon rate, term to maturity and credit quality. Understanding these properties can go a long way to helping you understand the role these assets play in a diversified portfolio.