Fixed-income securities: Meaning, Types, and risks involved

Fixed-income securities are investments where the cash flows are according to a predetermined amount of interest, paid on a fixed schedule. The following are the different types of fixed-income securities

• Government securities,
• Corporate bonds,
• Commercial paper,
• Treasury bills,
• Strips etc.

Getting the targeted amount at the exact time is a possibility of an investment in a fixed-income product. Fixed interest rate securities are those in which the interest payable is fixed in advance, distinct from floating interest rate securities where the interest payable is reset from pre-determined intervals according to a pre-determined benchmark.

Fixed-income securities are loans made by an investor to a government or corporate borrower unlike holders of equity that represents a share in the ownership of the issuer.

The key components of fixed-income securities are Credit quality, yield, and maturity. Credit quality is an indicator of the ability of the issuer of the fixed-income security to pay back his obligation. The credit quality of fixed-income securities is usually assessed by independent rating agencies such as Standard & Poor’s, Moody’s in the U.S., and CRISIL in India. Most large financial institutions also have their internal rating systems.

Coupon rate: Coupon rate (or simply a coupon) is the periodic rate of interest to be paid by the bond issuer to the bondholders. The coupon expressed as a percentage of the face value of the security gives the coupon rate. The coupon rate is calculated on the bond’s face value (or par value) not on the issue price or market value of the bond. For example, if you have a 12-year, Rs.5000 bond with a coupon rate of 8 percent, you will get Rs.400 every year for 12 years, irrespective of the changed price of that bond in the market.

Yield to Maturity (YTM): The difference between coupon rate and yield arises because the market price of a security might be different from the face value of the security. Since coupon payments are calculated on the face value, the coupon rate is different from the implied yield. Prices of the bonds and interest rates are inversely related. Therefore, the term ‘yield to maturity’ is used to indicate the returns an investor gets on his investments by reinvesting every periodic coupon payment from the bond at a fixed interest rate until the bond’s maturity date.

For example, if interest rates were currently gone up to 6% then the bonds with a coupon rate of 5% would be traded at a discount rate in the market. Since the coupon rate is calculated on the bond’s face value (or par value), not on the market value, YTM for the purchaser of such bonds from the market is higher than its coupon rate.

How YTM works:

If you have bought a bond at a discount of Rs.900 with a face value of Rs.1000 and it has a coupon rate of 10%. Let us say that there is exactly one year left on this bond. Now you will receive Rs.100 interest for Rs.900 for one year. Therefore, the yield on the bond is 100/900*100=11.11%. In this case, the yield is higher than the coupon rate. Conversely, a bond purchased at a premium always has a yield to maturity that is lower than its coupon rate.

Long-term securities typically offer more returns than short-term securities because investors usually prefer to lend money for shorter terms. Hence money lent out for longer terms will have a higher yield.

Callable securities:

Callable securities are those that can be called by the issuer at predetermined times/times, by repaying the holder of the security a certain amount which is fixed under the terms of the security.

Risks in Fixed Income securities:

Interest Rate Risk: If interest rates increase, the value of these securities may decrease. Remember, Prices of the bonds and interest rates are inversely related.

Credit risk includes default risk and inferior performance. Default risk is the possibility that the issuer will not pay the principal or coupon for the bond. The risk of inferior performance depends on the performance of other, similar bonds. Generally, it is safer to invest in Government security as default risk is nil or minimum.

Reinvestment Risk: Risk exists that interest generated won’t be able to be reinvested at the same rate.

Lower Potential Returns: They often provide lesser potential profits than equities.

Liquidity Risk: Some fixed-income instruments, particularly those with longer maturities or worse credit quality, may be difficult to sell rapidly without losing value.

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