You lend money to an issuer (a government or a company) for an agreed period. In return, you receive periodic interest payments (coupons) and at maturity you get your capital back. It is called 'fixed' because the interest is determined from day one.
Main types:
- Short-term government debt (for example, Letras del Tesoro in Spain, T-Bills in the US or CETES in Mexico): A short-term loan to the government (3, 6, 9, or 12 months). Bought 'at a discount' — you pay less than the face value and at maturity you receive the full amount. In financially sound countries, it is about as safe as it gets.
- Long-term government debt: Like short-term government debt but with maturities of 2, 5, 10, or 30 years. They pay periodic coupons.
- Corporate bonds: You lend to private companies. They pay more interest than government debt because their default risk is higher.
If you buy individual bonds, compound interest does not happen automatically. When you receive a coupon, the money arrives in your account and sits there — it does not reinvest itself. If you do nothing with it, you keep earning the same interest on the same initial capital every year. (Accumulating bond funds, on the other hand, do reinvest the coupons for you.)
To achieve the compound interest effect in fixed income, you have to actively reinvest what you receive: use the coupons to buy more fixed income, or at the maturity of a deposit, put everything — capital plus interest — into a new product. Only then do your returns start generating further returns.
If you need your money before maturity, you can sell the bond to another investor on the secondary market. The primary market is where the government or company issues the bond for the first time; the secondary market is where investors buy and sell bonds among themselves at market prices.
To avoid the risk of a single issuer: The simplest option for individuals is to buy a Global Fixed Income Index Fund, which invests in hundreds of bonds from different countries and companies at once.