Fixed Income Securities Definition

Fixed Income is defined as a type of financial instrument in which the issuer of the instrument (the borrower) is under the obligation to make fixed payments on fixed dates to the lender, and hence the term ‘fixed’ income is used. Fixed income securities come under debt financing as the borrower pays timely interest (monthly, quarterly, semi-annually, or any other frequency) and principal back at maturity to the borrower. In general, fixed income instruments are called bondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.read more, timely interest payments are called coupon payments, the principal is called the face value, and the interest rate that security carries is called the coupon rate. Fixed income instruments are generally used by governments and corporations to raise capital.

Types of Fixed Income

Different types of fixed income securities are –

Fixed

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Source: Fixed Income (wallstreetmojo.com)

Pricing of Fixed Income Securities

Price of a bondThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more is the present value of the future coupon payments and the present valuePresent value factor is factor which is used to indicate the present value of cash to be received in future and is based on time value of money. This PV factor is a number which is always less than one and is calculated by one divided by one plus the rate of interest to the power, i.e. number of periods over which payments are to be made.read more of the principal (face value). The formula for calculating the price is –

Price = [C1 / (1 + r)^1] + [C2 / (1 + r)^2] + [C3 / (1 + r)^3] + ………… + [(Cn + FVn) / (1 + r)^n]

where,

  • Cn – coupon payment in period n
  • r – interest rate
  • FV – Face value of the bond, i.e., the principal value.

From the above pricing formula of the bond, it can infer that the price of the bonds and interest rates are inversely related. And thus, three cases arise in relation to bonds, which are summarised below.

  1. Par bond – when the coupon rate of the bond and yield to maturityThe Yield Function in Excel is an in-built financial function to determine the yield on security or bond that pays interest periodically. It calculates bond yield by using the bonds settlement value, maturity, rate, price, and bond redemption.read more (interest rate) is the same. The bond will sell at its face value.
  2. Discount bond – when the coupon rate is less than the yield to maturityYield to Maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bonds expected returns after making all the payments on time throughout the life of a bond.read more of the bond. In this case, a bond will sell at a price lower than its face value.
  3. Premium bond – when the coupon rate that the bond carries is higher than the yield to maturity of the bond. The bond will sell at a premium pricePremium bonds are those long-term financial instruments which trade at a price exceeding their face value. The coupon rate of these bonds is higher because they tend to provide more interest than the standard rate of interest prevailing in the market.read more in this case (higher than the face value of the bond).

Example of Fixed Income

Let us now look at the calculation example of fixed income securities. Consider a bond with a face value (FV) of USD 1,000 and a coupon rate of 7%, which is paid annually. Time to maturity is 3 years. So, The coupon payments will be USD 70 every year, and USD 1,000 will be paid at maturity as a principal payment. So the cash flows will be USD 70 in year 1, USD 70 in year 2, and USD 1,070 in year 3 (coupon + FV).

  • Face Value: 1000
  • Coupon Rate: 7%
  • Maturity Period: 3
  • Coupon Payment at Each Year: 70
  • Coupon Payment at Maturity: 1070

We will have 3 scenarios here –

#1 – Interest rate is equal to a coupon rate of 7%

fixed

P = [70/(1 + 0.07)^1] + [70/(1 + 0.07)^2] + [1,070/(1 + 0.07)^3] = USD 1,000

This bond is selling ‘at par’i.e. at its face value.

#2 – Interest rate (say 8%) is higher than the coupon rate

example

P = [70/(1 + 0.08)^1] + [70/(1 + 0.08)^2] + [1,070/(1 + 0.08)^3] = USD 974.23

This bond is selling ‘at a discount,’ i.e., at a price lower than its face value.

#3 – Interest rate (say 6%) is higher than the coupon rate

Example

P = [70/(1 + 0.06)^1] + [70/(1 + 0.06)^2] + [1,070/(1 + 0.06)^3] = USD 1,026.73

This bond is selling ‘at a premium,’i.e., at a price higher than its face value.

Advantages of Fixed Income

Advantages of fixed income securities/markets are-

Disadvantages of Fixed Income

There are some cons associated with F.I. securities too. These are –

Conclusion

Fixed income instruments are used by investors to diversify their portfolios as they carry fewer risks in general compared to equities. They also provide a source of regular fixed income and allow the investor to invest as per their risk appetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation.read more. However, they come with their own sets of risks such as credit risk, interest rate risk, liquidity risks, etc.

This has been a guide to what is Fixed income and its definition. Here we discuss types of fixed income securities along with pricing examples, advantages, and disadvantages. You can learn more about Fixed Income from the following articles –

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