Fixed income securities are a broad class of very liquid and highly traded debt instruments, the most common of which is a bond. They generally provides returns in the form of regular interest payments and repayments of the principal when the security reaches maturity.
They are different from equities, or stocks, since fixed income securities do not represent an ownership interest in a company, but they confer a seniority of claim, as compared to equity interests, in cases of bankruptcy or default.
The instruments are issued by governments, corporations, and other entities to finance their operations. Investors buy fixed income securities to provide a predictable cashflow and to provide diversification from stocks and other asset classes.
Fixed income securities are a broad class of very liquid and highly traded debt instruments, the most common of which is a bond.
Fixed Income Securities can be issued by companies and government entities and can take many forms.
Investors look to Fixed Income Securities for high-quality, diversified and liquid returns but there are risks for Fixed Income Securities as well, such as inflation, interest rate and default risk.
How Does Fixed Income Work?
The term fixed income refers to the interest payments that an investor receives, which are based on the creditworthiness of the borrower and current interest rates.
Generally speaking, fixed income securities such as 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 demand higher rates to commit their savings for a longer amount 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.” The illustration below shows the cash flows that an investor might receive if they purchase a 3 year bond (where t denotes the time in years).
Examples of Fixed Income Securities
The most common type of fixed income security is a bond, both issued by companies and government entities, but there are many examples of fixed income securities as money market instruments, asset-backed securities, preferreds and derivatives.
The topic of bonds is, by itself, a whole area of financial or investing study. In general terms, they can be defined as loans made by investors to an issuer, with the promise of repayment of the principal amount at the established maturity date, as well as regular coupon payments (generally occurring every six months), which represent the interest paid on the loan. The purpose of such loans ranges widely. Bonds are typically issued by governments or corporations that are looking for ways to finance projects or operations.
2. Money Market Instruments
Money market instruments include securities such as commercial paper, banker’s acceptances, certificates of deposit (CD), repurchase agreements (“repo”) and the most traded, US Government Treasury Bills, called T-bills for short.
Considered the safest short-term debt instrument, Treasury bills are issued by the US federal government. With maturities ranging from one to 12 months, these securities most commonly involve 28, 91, and 182-day (one month, three months, and six months) maturities. These instruments offer no regular coupon, or interest, payments.
Instead, they are sold at a discount to their face value, with the difference between their market price and face value representing the interest rate they offer investors. As a simple example, if a Treasury bill with a face value, or par value, of $100 sells for $90, then it is offering roughly 10% interest.
3. Asset-Backed Securities (ABS)
Asset-backed Securities (ABS) are fixed income securities backed by financial assets that have been “securitized,” such as 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, asset-backed securities are usually an alternative to investing in corporate debt.
Sometimes called Subordinated Debt, these type of fixed income securities rank lower on the capital stack. Preferred fixed income securities may not pay their coupon or principal should the creditworthiness of the issuer deteriorate. This risk is called loss-absorption and hence Preferreds are sometimes viewed as a hybrid security between fixed income and equities.
In capital markets, there have been many financial contracts that have different payoffs depending on how other securities behave. These are called “Derivatives” and in fixed income, we see these derivatives such as swaps, options and structured products actively traded for speculation, hedging and getting access to additional assets or markets.
Who invests in Fixed Income Securities?
Institutional Investors and Retail Investors both invest in Fixed Income Securities. Each one of these types investors have different considerations when investing in fixed income though.
Some of these considerations might be:
Liquidity – Fixed Income Securities are one of the most liquid types of investments, trading around the clock in most currencies;
Diversification – investors may choose bonds to diversify their portfolios or to seek safer investments, such as government bonds – also known as “flight-to-quality”.
Matching investor liabilities – for investors that require certainty of cash-flows, such as pension funds or retirees, Fixed Income Securities provide an easier way of managing their income so that they can match their obligations.
Risks of Investing in Fixed Income Securities
It is important to remember that while certain types of bonds are low-risk, bonds are not always less risky than equities.
In general, investors in Fixed Income Securities face four major risks:
Inflation – inflation is the general increase in price levels over a given time. Since Fixed Income Securities tend to be longer-lived and most do not have an adjustment to account for inflation, rising price levels eats away at the purchasing power of the cash flows on Fixed Income Securities, making it a risk for investors.
Interest rate risk – the risk that changes in interest rates may reduce the market value of a fixed-income security that an investor holds. For example, if an investor holds a 10-year bond that pays 3% interest, but then later on interest rates rise and new 10-year bonds being issued offer 4% interest, then the bond the investor holds that pays only 3% interest becomes less valuable and the price of that security falls.
Default Risk – Principal risks associated with fixed-income securities concern the borrower’s vulnerability to defaulting on its debt. Such risks are incorporated in the interest or coupon that the security offers, with securities with a higher risk of default offering higher interest rates to investors.
Additional risks include exchange rate risk if investors buy securities denominated in a foreign currency, as well as the risk of capital controls that would forbid investors to get their investment back.
Thank you for reading CFI’s guide to Fixed Income Securities. To keep advancing your career, the additional CFI resources below will be useful: