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Main Findings
Fixed-income securities are a broad class of debt instruments that provide investors with regular interest payments and repayment of principal at maturity. Fixed income offers several benefits for investors, such as predictable cash flow, diversification from stocks and other asset classes, lower volatility, and higher safety. However, they also have some limitations, such as inflation risk, interest rate risk, default risk, and exchange rate risk.
Fixed income is a type of investment that pays a fixed amount of interest or dividends on a regular schedule.
Fixed-income securities are issued by governments, corporations, or other entities that need to borrow money for various purposes. Fixed-income investors lend their money to the issuers and receive periodic payments until the maturity date when they get back their principal amount. Fixed-income securities are also known as bonds or debt instruments.
Why invest in fixed income?
Investing in fixed income can provide several benefits, such as:
Steady Income
Fixed-income securities can generate a predictable stream of cash flow for investors, which can be useful for budgeting or meeting financial goals.
Capital Preservation
Fixed-income securities typically have lower volatility and risk than stocks, which means they are less likely to lose value in the short term. Fixed-income securities also have a legal claim on the issuer's assets in case of default or bankruptcy, which gives them priority over equity holders.
Diversification
Fixed-income securities can have different characteristics and performance than stocks, which can help reduce the overall risk and enhance the return of a portfolio. Fixed-income securities can also have different sensitivities to various factors, such as interest rates, inflation, credit quality, and duration, which can allow investors to customize their exposure and hedge against different scenarios.
The formula for fixed-income valuation
The basic formula for valuing fixed-income security is:
Present value = Sum of discounted cash flows
This means that the value of a fixed-income security is equal to the sum of all the future cash flows (interest payments and principal repayment) discounted by an appropriate interest rate (also known as the discount rate or yield).
For example, suppose a bond pays 5% annual interest on a $1,000 face value and matures in 10 years. If the discount rate is 6%, the present value of the bond is:
Present value = ($50 / 1.06) + ($50 / 1.06^2) + ... + ($50 / 1.06^10) + ($1,000 / 1.06^10)
Present value = $907.03
This means that an investor would be willing to pay $907.03 for this bond today, given the expected cash flows and the discount rate.
How to calculate fixed income yield
The yield of a fixed-income security is the annualized return that an investor would earn if they bought the security at its current price and held it until maturity. The yield can be calculated by using the following formula:
Yield = (Annual cash flow / Current price) ^ (1 / Years to maturity) - 1
For example, suppose a bond pays 5% annual interest on a $1,000 face value and matures in 10 years. If the current price of the bond is $950, the yield is:
Yield = ($50 / $950) ^ (1 / 10) - 1
Yield = 0.0536 or 5.36%
Examples
There are many examples of fixed-income securities in the market, each with different characteristics and risk profiles. Here are some of the most common ones:
Treasury bonds
These are issued by the U.S. government and are considered to be the safest and most liquid fixed-income securities. They have maturities ranging from one month to 30 years and pay semiannual coupons. The interest income from treasury bonds is exempt from state and local taxes, but not federal taxes.
Corporate bonds
These are issued by companies to raise capital for various purposes, such as expanding operations, refinancing debt, or acquiring other businesses. They have maturities ranging from one year to 30 years and pay semiannual coupons.
The interest income from corporate bonds is subject to federal, state, and local taxes. Corporate bonds are rated by credit rating agencies based on the issuer's creditworthiness and default risk. The higher the rating, the lower the interest rate, and vice versa.
Municipal bonds
These are issued by state and local governments or their agencies to fund public projects, such as schools, roads, hospitals, or utilities. They have maturities ranging from one year to 40 years and pay semiannual coupons. The interest income from municipal bonds is exempt from federal taxes and may also be exempt from state and local taxes if the investor resides in the same jurisdiction as the issuer.
Certificates of deposit (CDs)
These are issued by banks or credit unions to attract deposits from savers. They have maturities ranging from a few months to five years and pay fixed interest rates at regular intervals. The interest income from CDs is subject to federal, state, and local taxes. CDs are insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per depositor per institution.
Fixed-income exchange-traded funds (ETFs)
These are funds that track the performance of a basket of fixed-income securities, such as treasury bonds, corporate bonds, municipal bonds, or international bonds. They trade on stock exchanges like stocks and offer diversification, liquidity, and low fees. The interest income from fixed-income ETFs is subject to federal, state, and local taxes. Fixed-income ETFs may also have capital gains or losses when sold.
Limitations
Fixed-income securities have some limitations that investors should be aware of before investing in them. Some of the main limitations are:
Inflation risk
This is the risk that the purchasing power of the fixed-income payments will decline over time due to rising prices. Inflation reduces the real return of fixed-income securities and erodes their value. To protect against inflation risk, investors can choose fixed-income securities that have inflation-adjusted payments, such as Treasury Inflation-Protected Securities (TIPS) or inflation-linked bonds.
Interest rate risk
This is the risk that the market value of fixed income securities will fluctuate due to changes in interest rates. When interest rates rise, the market value of fixed-income securities falls, and vice versa. This is because investors demand higher yields for existing fixed-income securities to match the new higher rates available in the market.Â
To protect against interest rate risk, investors can choose fixed-income securities that have shorter maturities or lower durations, which measure the sensitivity of a fixed-income security's price to changes in interest rates.
Default risk
This is the risk that the issuer of a fixed-income security will fail to pay the principal or interest on time or at all. Default risk is higher for fixed-income securities that have lower credit ratings or are issued by entities that have weaker financial positions or face economic or political challenges. To protect against default risk, investors can choose fixed-income securities that have higher credit ratings or are backed by collateral or guarantees.
Exchange rate risk
This is the risk that the value of fixed-income securities denominated in foreign currencies will fluctuate due to changes in exchange rates. Exchange rate risk affects investors who invest in international fixed-income securities or funds that hold them.Â
When the foreign currency depreciates against the domestic currency, the value of the fixed-income payments decreases in domestic currency terms, and vice versa. To protect against exchange rate risk, investors can hedge their currency exposure using derivatives or choose fixed-income securities that are denominated in their domestic currency.
Conclusion
Fixed-income securities are a broad class of debt instruments that provide investors with regular interest payments and repayment of principal at maturity. They offer several benefits for investors, such as predictable cash flow, diversification from stocks and other asset classes, lower volatility, and higher safety.Â
However, they also have some limitations, such as inflation risk, interest rate risk, default risk, and exchange rate risk. Therefore, investors should carefully consider their investment objectives, risk tolerance, time horizon, and tax situation before investing in fixed-income securities.
References
- Investopedia (2023). Fixed-Income Security Definition, Types, and Examples. https://www.investopedia.com/terms/f/fixed-incomesecurity.asp
- Corporate Finance Institute (n.d.). Fixed Income Securities. https://corporatefinanceinstitute.com/resources/fixed-income/fixed-income-securities/
- Investopedia (2023). Guide to Fixed Income: Types and How to Invest. https://www.investopedia.com/terms/f/fixedincome.asp
FAQ
While both are forms of debt, a bond is a type of fixed-income security that is traded on the open market, while a loan is typically a private agreement between a borrower and a lender.
Inflation erodes the purchasing power of the fixed interest payments that bonds make, which can lead to a decrease in the bond’s price.
A yield curve is a graphical representation of the interest rates on debt for a range of maturities. It shows the relationship between the interest rate (or cost of borrowing) and the time to maturity of the debt.
Corporate bonds are issued by companies, while government bonds are issued by the government. Corporate bonds typically offer higher yields to compensate for the additional risk compared to government bonds.
A junk bond is a bond that carries a higher risk of default than most bonds issued by corporations and governments. As a result, they offer a higher yield to attract investors.
If the coupon rate is higher than the market interest rate, the bond’s price will typically be higher than its face value, and vice versa.
Duration is a measure of the sensitivity of a bond’s price to changes in interest rates. The higher the duration, the more a bond’s price will drop as interest rates rise.
Convexity is a measure of the curvature of how the price of a bond changes as the interest rate changes. It is used as a risk-management tool to gauge the effect of interest rate changes on a bond’s price.
Credit rating agencies assess the creditworthiness of bond issuers, which can affect the interest rate that the issuer must pay to borrow funds.
Securitization is the process of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling their related cash flows to third party investors as securities.
