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 –
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Source: Fixed Income (wallstreetmojo.com)
- Fixed-rate bonds – the coupon rateThe coupon rate is the ROI (rate of interest) paid on the bonds face value by the bonds issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more of fixed-rate bonds are agreed upon at the issuance of the bond, and the borrower makes fixed interest payments to the lender on the coupon dates.
- Floating rate bonds – the coupon rate of floating-rate bonds are linked to some market rates like LIBOR, and the interest payments are made as per the market rates applicable in that period.
- Zero-coupon bonds – Zero-Coupon Bonds don’t make any interest payments over the life of security and make principal as well interest payment together at maturity.
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]
- 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.
- 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.
- 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.
- 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%
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
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
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-
- It provides a steady source of income to the investors as the lender/ investor as they receive interest payments at regular intervals.
- Prices of fixed income securities are less volatile than those of equity securities.
- Investors can invest in this income securities as per their risk appetite. Government bonds are virtually considered risk free, while corporate bonds carry credit risk. Thus govt. issued bonds give less return, and corporate bonds provide higher returns.
- In addition to timely coupon payments, if the fixed income security is sold prior to its maturity, the security may also provide capital gain returns too. The price of F.I. securities depends on the market interest rates, and if sold in favorable market conditions, F.I. securities can provide capital appreciation returnCapital appreciation refers to an increase in the market value of assets relative to their purchase price over a specified time period. Stocks, land, buildings, fixed assets, and other types of owned property are examples of assets.read more too.
Disadvantages of Fixed Income
There are some cons associated with F.I. securities too. These are –
- In general, equities provide higher returns as compare to fixed income securities. This may not always hold, but over a long period of time, equities provide higher returns.
- They carry risks which are outlined below-
- Liquidity risk – Fixed Income securities are generally less liquid than equities, and an investor might have to sell F.I. securities at a lower price to liquidate his/ her holding.
- Credit risk – These securities carry the risk that the issuer may not be able to able to make the timely interest or principal paymentThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loans original amount is directly reduced.read more at maturity and default on its obligations.
- Interest rate risk – the price of these income securities Is inversely proportional to market interest rates. So, as market interest rate increase, the price of such securities go down.
- Inflation risk – with rising inflation, the purchasing power of timely interest payments is reduced.
- Call risk – a callable bondA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bonds maturity. This right is exercised when the market interest rate falls.read more is the one in which the issuer can call (repay) the bonds earlier than the maturity date. If the interest rate decreases, i.e., the price of the bonds increases, then the issuer can call the bonds earlier, and the overall return of the investor will be reduced.
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 –