Fixed Income Securities

Fixed-income securities are described as securities where investors offer capital to corporations or a government for a fixed duration in return for regular interest payments and the original principal at maturity. Compared to equity and equity-linked instruments, fixed-income securities are considered to be safer as most of them offer guaranteed returns and come with low risks. In this article, we will be learning what fixed-income securities are, how they work, what are their types, their benefits and what should one consider before investing in them.

Fixed-income securities are a broad class of very liquid and highly traded debt instruments. Often, companies and governments need to take loans from the public in exchange for interest payments. These fixed-income securities can be issued by a corporation, government, or any other entity to raise debt. These entities become borrowers and the public becomes the lender. These instruments are also commonly known as bonds or money market instruments.

The reason they are called fixed-income securities is that they offer periodic income payments at a predetermined fixed interest rate. The borrower issues bonds to raise debt from investors by promising to repay the principal on a fixed date and to make pre-scheduled interest payments.

The term fixed income refers to the interest payments that the investor receives and these interest payments are based on the creditworthiness of the borrower and current interest rates.

Usually, fixed-income securities like bonds pay a higher interest, known as the coupon, the longer their maturities. This is because borrowers are willing to pay more interest in return for being able to borrow the money for a longer period of time and investors ask for higher interest rates to commit their savings for a longer period of time. At the end of the security's term or maturity, the borrower returns the borrowed money, known as the principal or "par value".

Let's take a look at an example to understand this better. ABC Corporation is looking to raise capital to expand its business. The company has the highest possible *bond rating and needs ₹10 crores. The company wishes to sell bonds with a par value of ₹10,000.

(*Bond rating - These are third-party evaluations of how likely a company or government agency is to pay interest on fixed-income securities and return principal)

If you buy a bond directly from ABC, you will be paying the face value. Bonds trade in the secondary market and may trade above par, at a premium, or below par at a discount. Let's say, you bought the bonds directly from ABC and hold them until maturity. The bonds pay 4% semiannually on the face value of ₹10,000 and mature in 10 years. Under this scenario, each bond pays ₹400 annually in two payments of ₹200 each. At the end of 10 years when the bond matures, ABC will repay the ₹10,000 principal and you will have earned ₹4000 in interest.

Whenever anyone mentions fixed-income securities, most of us will immediately think of bonds. But there are several types of fixed-income securities, including debt mutual funds, bank fixed deposits, treasury bills, and more.

They invest their corpus primarily in several debt instruments like bonds, treasury bills, etc. Investment in these instruments ensures stable returns for the investors. Also, these funds invest in debt securities with good credit ratings. Hence, the chances of default of payment on these securities are minimal. When you compare debt mutual funds to equity mutual funds, you can see how the former is relatively less risky, making it an ideal investment option for risk-averse investors.

They are one of the safest categories of fixed-income securities. A fixed deposit offers a fixed interest rate on your principal investment. It is offered by almost every bank in India. With fixed deposits, you make a lumpsum investment, which will earn interest during the deposit period. At maturity, the investor will get the principal and the accrued interest. Different banks offer fixed deposit accounts with different maturities. You can choose FD accounts with maturity periods ranging from 7 days to 10 years.

In recurring deposits, you will deposit a small amount of money as a monthly installment for a fixed period of time. The duration ranges from 1 year to 10 years in an RD. The interest rate is the same as that of fixed deposits. This helps you save small amounts of money to accumulate a sizable corpus in the long run.

Bonds are one of the most common types of tools in the category of fixed-income securities. As explained in the example above, a bond is an obligation or loan made by a borrower to a buyer. In turn, the borrower promises to repay the bond's principal (or face value) on a fixed maturity date and to make regularly scheduled interest payments. Most bonds are issued by governments and corporations.

They are used by companies to manage their working capital requirements. Like other fixed-income security, they too carry a fixed rate of return. On the other hand, they are not long-term and their maturity period usually is at most a year. Money market instruments include securities like commercial paper (CP), certificates of deposit (CD), repurchase agreements (repo), treasury bills (T-bills), and so on. These fixed-income bonds in India are sold over the counter. Hence, they are not accessible to standalone investors. It can only be purchased via money market mutual funds.

They are issued by the central government to raise money. They have short-term maturities, with the highest up to one year. At present, T-Billes are issued with 3 different maturity periods, including 91 days T-Bills, 182 days T-Bills, and 1-year T-Bills.

These bills are issued at a discount to the face value. At maturity, the investor gets the face value amount. The difference between the initial value and face value is the return earned by the investor. They are one of the safest short-term fixed-income investments, as they are backed by the Government of India.

When you invest in PPF, you can earn higher returns and also, claim tax deductions. It has zero risks associated with it, as it is a Central Government sponsored scheme.

This scheme aims to offer financial securities to our country's senior citizens. People above the age of 60 can invest their funds, which earn a substantial interest rate fixed by the ministry of finance.

These are fixed-income securities backed by financial assets that have been "securitized" like credit card receivables, auto loans, or home-equity loans. ABS represents a collection of such assets that have been packaged together in the form of a single fixed-income security. For investors, ASBs are usually an alternative to investing in corporate debt.

They are formal agreements between two parties, where one party sells a security to another, with the promise of buying it back at a later date from the buyer. It is also called a Sell-Buy transaction.

The seller will buy the security at a predetermined time and amount. This agreement will also include the interest rate at which the buyer agreed to buy the security. The interest rate charged by the buyer for agreeing to buy the security is called the Repo rate. Repos come in handy when the seller needs funds for the short term, so they just sell the securities and get the funds. The buyer gets an opportunity to earn good returns on the invested money.

There are several benefits to investing in fixed-income securities.

Stable Returns - One of the major benefits of investing in fixed-income securities is the stability of returns that are offered by them. Since these instruments have a fixed interest rate, the returns offered by them are more or less stable. Hence, these instruments are a better alternative to bank savings accounts, which offer a minimal interest rate on your deposits.

Diversification - When you invest in fixed-income securities, your portfolio gets a much-needed diversification, especially if your portfolio has high exposure to equities. We all like to invest in equities as they offer high returns, but high returns also come with volatility. So, to make your investment portfolio stable, it is crucial to make a considerable amount of investment in highly rated debt securities.

Low Risk - Since many of the fixed securities are backed by the government, large banks, and corporates, they carry a relatively low risk. However, you should always do your due diligence and check the security's rating before investing.

Priority During Liquidation - In case the issuer goes bankrupt, it is liable to pay back to its debtors and stockholders. However, the issuer may not have enough assets to pay off both. In such cases, the investors in fixed-income securities get a priority in being paid back before the other stakeholders. The senior secured debt holders will be paid first, followed by other investors. The equity investors and promoters are the last parties to be paid.

We saw how fixed-income securities can bring stability to your investment portfolio, help you earn stable returns, and carries fewer risks than equity instruments. Even though they carry fewer risks than equities, they still carry certain risks. Below is a list of risks carried by these securities and it is important to know about them before investing in them.

Stable Returns - One of the major benefits of investing in fixed-income securities is the stability of returns that are offered by them. Since these instruments have a fixed interest rate, the returns offered by them are more or less stable. Hence, these instruments are a better alternative to bank savings accounts, which offer a minimal interest rate on your deposits.

Credit Risk - Government institutions or private corporations can issue fixed-income assets. Even though the risk of government defaulting is zero, private entities can default. Hence, investors are exposed to the issuer's credit risk in securities issued by private entities, including banks, corporations, etc. Credit risk simply means when the issuer of the bond or debt security defaults on the timely payments of interest and the principal amount. To reduce credit risk, investors should invest in those securities that have a high credit rating.

Interest Rate Risk - This risk means that changes in interest rates may reduce the market value of a fixed-income security that an investor holds. For example, you buy a 10-year bond that pays 3% interest, but then later on, interest rates rise and the new 10-year bonds that are issued offer 4% interest. This means that the bond that you hold, which pays 3%, becomes less valuable and the price of that security falls.

Inflation Risk - Inflation is the general increase in price levels over a given time. We all know that many fixed-income investment options are long-term securities with a fixed return. Hence, persistent inflation could erode their actual recovery. On the other hand, market-linked securities automatically adjust as per the inflation rate in the economy.

Liquidity Risk - Some fixed-income securities may be illiquid in nature (i.e.) there may not be an active market where the investors can sell their investment. Also, some fixed-income investments may have a lock-in period before which an investor cannot exit while some may have penalties for premature withdrawal or exit loads (for example, fixed deposits).

Reinvestment Risk - This risk entails the possibility that you won't be able to reinvest cash flows from a particular investment at a rate similar to the current return. Such a situation leads to an opportunity cost for the investor. Reinvestment risk is generally higher with securities with high coupon rates and long reinvestment periods.

Fixed-income securities are an ideal investment option for conservative investors, who wish to earn stable returns and don’t want to take high risks. They are also a perfect option for those who wish to add stability to their investment portfolio. There are several fixed-income securities, such as debt mutual funds, and fixed deposits, which would be a great addition to every investor’s portfolio, including newbies and experienced investors.

We hope this article helped you understand everything about fixed-income securities, their types, benefits, and risks involved in investing in them. If you wish to learn more about other asset classes, and investment instruments, head over to our Blogs section. You can also check out our calculators to see how much wealth you will accrue when you invest in various investment instruments.

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