In the previous module you learned that Asset Allocation divides your portfolio into three blocks: fixed income, equities, and alternative assets. Now we will look at what each one is. We start with fixed income: lending your money to an institution — a government or a company — in exchange for them returning it on an agreed date plus fixed interest. It is called 'fixed' because, if you hold the investment until maturity and the issuer pays, you know in advance how much you will earn and when. It is the most predictable investment category, though it is not zero risk: if the borrower defaults, you can lose some or all of your money; and if you need to sell before maturity, the price may have fallen (this happens when interest rates rise: in 2022 global bonds fell by around 16%).
Two main types:
- Government bonds (sovereign bonds and short-term government securities): You lend money to a country. Those of highly creditworthy governments are among the safest investments in the world: the probability of them not paying you is very low, and the return is usually low precisely for that reason. But not all governments are equally creditworthy: Greece restructured its debt in 2012 and Argentina has defaulted nine times.
- Corporate bonds: You lend money to private companies. Since a company's default risk is higher, companies pay you more interest to compensate. Higher return, higher risk.
You buy a government bond at 3.5% per year. You lend $1,100 to the state. In a year, the state pays you back $1,139. If instead you lend to a medium-risk company at 6% per year, you earn more — but you accept the risk that the company might struggle to pay.
There is a dedicated module on fixed income further ahead where you will see all its instruments in detail, how they are valued, and how they fit into a portfolio.