What are fixed income instruments?
Fixed income refers to investment securities that pay investors a fixed interest or dividend payment until the maturity date at which the investors receive the original amount they invested. Government bonds and corporate bonds are the most common fixed income instruments, and they differ from investments such as stocks and variable income securities in that they provide unchanging cash flows.
This article will tell you everything you need to know about fixed income, what it is, its tools, advantages and risks, in addition to an illustrative example that brings you closer to how it works.
Advantages of fixed income instruments
Corporations and governments issue debt securities to raise funds for interest financing of day-to-day operations and large projects. Fixed income instruments pay a set interest rate return in return for lending investors their money, and the original amount invested by investors, also known as the principal, is paid back at maturity.
The company may issue a 5% bond of $1,000 that matures in five years. The investor buys the bond for $1,000 and will not be repaid until the end of the five years, but will simultaneously receive the interest or coupon payments over the specified term. In other words, the investor would be paid $50 annually for five years, and then receive $1,000 on the due date.
Treasury bonds, municipal and corporate bonds, and certificates of deposit are all examples of fixed income instruments. These investments are ideal for investors who aspire to obtain a diversified portfolio, as there are opportunities to diversify the portfolio with a mixture of fixed-income products, stocks, and other investments.
Special considerations
Fixed income investing is a conservative strategy in terms of the lack of risk and the ease of predicting the interest you pay. Building a fixed income portfolio may include investing in bonds, bond mutual funds, certificates of deposit, etc.
The scaling strategy is one of the most common fixed income investment strategies, which provides a steady interest income by investing in a series of short-term bonds. After the bond matures, the portfolio manager reinvests the returned capital into new, short-term bonds to extend the ladder. This strategy protects the investor from the loss of high interest rates in the market and gives him access to ready capital.
An investment of $60,000 can be divided into one-year, two-year, and three-year bonds. The principle investor divides the $60,000 into three equal parts, investing $20,000 in each of the three bonds. When the bond matures for one year, the principal of $20,000 will be converted into a bond that matures one year after the original three-year contract. When the second bond matures, that money rolls over into a bond that extends the ladder for another year. This way the investor gets a steady return of interest income and can take advantage of any higher interest rates.
Types of fixed income instruments
As mentioned earlier, the most common example of a fixed income security is government bonds or corporate bonds. The most common government securities are those issued by the US government and are commonly referred to as Treasury securities, but many fixed income securities are offered by non-US governments and corporations as well. Here is a list of the most popular fixed income instruments:
Treasury bills are short-term, fixed-income securities that mature within one year and do not pay coupon returns. Investors buy the bill at less than its face value and the investors earn the difference at maturity.
Treasury bonds are bonds that come in maturities between 2 and 10 years and pay a fixed interest rate. At the end of the maturity date, the investors are paid back the principal but also receive semi-annual interest payments until the maturity date.
Treasury inflation-protected bonds that protect investors from inflation, as the principal amount of the bond is adjusted depending on the rates of inflation and deflation.
Municipal bonds that are issued and backed by a state, municipality, or province rather than the federal government, and are used to raise capital to fund local expenditures.
Corporate bonds come in various types, and the price and interest rate offered depends largely on the company’s financial stability and creditworthiness. Bonds with higher credit ratings usually pay lower coupon rates.
Junk bonds, also called high-yield bonds, are corporate issues that pay a higher coupon due to the higher risk of default.
A certificate of deposit is a fixed income instrument offered by financial institutions with maturities of less than five years.
Fixed income mutual funds or bond funds that invest in various debt instruments.
ETFs are an investment vehicle that targets these specific credit ratings, periods, or other factors. ETFs also incur professional management expenses.
Advantages of fixed income instruments
Fixed income instruments provide investors with a steady stream of income over the life of the bond as well as recurring interest payments that help them stabilize the return on risk in their investment portfolio which is known as market risk. Equity volatility will not greatly affect the investor if his portfolio includes a type of fixed income investment that may partly offset the losses caused by the decline in share prices.
Although there are many benefits of fixed income instruments, there are many risks that investors should be aware of before making their decision.
Risks associated with fixed income instruments
Credit risk and default
When choosing the right investment for you, be sure to look at the credit rating of the bond and the underlying company. While treasury bonds and certificates of deposit enjoy government protection, there are many fixed income instruments that do not provide the same levels of protection. If an investor tries to sell a bond to a distressed company for example, the bond may be sold for less than face value.
Bond prices can increase and decrease over the life of the bond. The investor will not be affected by these price movements if he holds the bond until its maturity date, but if he sells it before maturity through a broker or financial institution, he will get the current market price at the time of sale.
Interest rate risk
Fixed income investors may face interest rate risk that occurs in an environment where interest rates rise in the market, and the price that the bond pays declines causing it to lose value in the secondary bond market. In addition, the investor’s capital is restricted, so if an investor buys a two-year bond that pays 2.5% annually, for example, and interest rates on the two-year bond jump to 5%, the investor is locked in at 2.5% for better or for worse.
Inflation risks
Inflation greatly affects investors in fixed income instruments, so the gains of fixed income securities will decrease if prices rise or inflation increases. If a fixed-rate debt security pays a return of, say, 2%, and inflation rises by 1.5%, the investor will only make a return of 0.5% in real terms.
Pros and Cons
Positives
- Steady income stream
- More stable returns than stocks
- The possibility of claiming assets in bankruptcy cases
- Government and FDIC support on some fixed income instruments
Negatives
- Lower returns than other investments
- Exposure to credit risk and default
- subject to interest rate risk
sensitivity to inflation
An example of fixed income
Let’s say PepsiCo (PEP) is offering a fixed-income bond for a new bottling plant in Argentina. The bonds issued at 5% are available at face value of $1,000 each and are due for repayment within five years, and the company plans to use the proceeds from the new plant to pay down the debt.
You purchase 10 bonds with a total cost of $10,000, meaning you will receive $500 in interest payments each year for five years (0.05 x $10,000 = $500). After the company uses the original to build the overseas factory, it will repay the original amount five years after receiving it.
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