In this article, Jayati WALIA (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) presents fixed-income products.
Fixed-income products are a type of debt securities that provides predetermined returns to investors in terms of a principle amount at maturity and/or interest payments paid periodically up to and including the maturity date (also known as coupon payments). For investors, fixed-income securities pay out a fixed set of cashflows that are known in advance and are hence preferred by conservative investors with low-risk appetite or those looking to diversify their portfolio and limit risk exposure. For companies and governments issuing these securities, it is a mechanism to raise capital to fund operations and projects.
The most elementary type of fixed-income instrument is the coupon-bearing bond. The values of different bonds depend on the coupon size, maturity date and market view of future interest rate behaviours (or essentially bond market yields). For eg., prices of bonds with longer maturity fluctuate more by interest rate changes. Bonds are generally traded OTC unlike equity stocks that are traded via exchanges. The risk exposure of a bond can be gauged by their Credit Rating issued by rating agencies (S&P, Moody’s, Fitch). The least risky bonds have a rating of AAA which indicates a high measure of credit worthiness and minimum degree of default.
Fixed-income products can come in many forms as well which include single securities like treasury bills, government bonds, certificate of deposits, commercial papers and corporate bonds, and also mutual funds and structured products such as asset back securities.
Types of fixed-income products
Fixed-income products come in several structures catering to the needs of investors and issuers. The most common types are explored below in detail:
Treasury bills (also called “T-bills”) are money market instruments that are issued by governments with a short maturity ranging from one month to one year. These bills are used to fund short-term financing needs of governments and are backed by the Treasury Department. They are issued at discounted value and redeemed at par value. The difference between the issuance and redemption price is the net gain or income for the investor. The T-Bills are generally issued in denomination of $1,000 per bill. For example, if you buy a T-bill issued by the US Department of Treasury with a maturity of 52 weeks at $990, you will redeem your T-bill at a price of $1,000 upon maturity.
Treasury notes and bonds
Treasury notes and bonds are a type of fixed-income security issued by governments with a medium or long maturity beyond one year. These bonds are used to fund permanent financial needs of governments and are backed by the Treasury Department. They come with predetermined interest payments. They are considered to be the safest investment since they are backed by the government. As a consequence, government bonds come with low returns. Government bonds are usually traded over the counter (OTC) markets. Technically, government bonds come in various forms: zero-coupon bonds, fixed payment and inflation protected securities.
Corporate bonds, as the name suggests, are issued by corporations to finance their investments. They generally come with higher yields as compared to the government bonds as they are perceived as more risky investments. The expected return for such bonds generally depends on the company’s financial situation reflected in its credit rating. Corporations can issue different types of bonds which includes zero-coupon bonds, floating-rate bonds, convertible bonds, perpetual bonds, and subordinated bonds.
Asset-backed securities (ABS) is a kind of fixed-income product that comprises of multiple debt pools packaged together as a single security (also known as ‘securitization’) and sold to investors. The assets that can be securitized include home loans (mortgages), auto loans, student loans, credit card receivables among others. Thus the interest and principal payments made by consumers of the individual debts are passed on to the investors as the yield earned on the ABS.
Benefits of fixed-income products
Generally, fixed-income products are issued by governments and corporations to raise capital for their operation.
For firms, the issuance of bonds in financial markets along with bank credit (two types of debt) allows firms to use leverage. Interests can also be deduced from income such that the firm will pay less taxes.
The investment in fixed-income products is considered to be a conservative strategy as it presents low returns (compared to stocks) but also provides a relatively low-risk exposure. Other benefits include:
- Capital protection: Fixed income products carry less risk as compared to other asset classes such as stocks. These investments ensure capital preservation till the maturity of the investment and are preferred by investors who are risk averse and look for stable returns.
- Generation of predetermined income: The income from fixed-income products is generated by means of interest or coupon payments. The income level for such products is predetermined at the time of investment and is paid on a regular basis (usually semi-annually or annually). Also, investors benefit from income tax exemption on investment in many fixed-income products.
- Seniority rights: The holders of corporate bonds get seniority rights in terms of repayment of their capital if the company goes into bankruptcy.
- Diversification: The fixed-income markets are less sensitive to market risk compared to the equity markets. So, the fixed-income products are considered to be less risky than the equity market investments and generally provides a fixed or stable stream of income. To manage the risk exposure for any portfolio, investors prefer investing in fixed income products to diversify their investments and offset any losses which may result from the equity markets.
Risks associated with fixed-income products
While fixed-income securities are considered to provide relatively low risk exposure, volatility in the bond market may still prove tricky. Bond value and interest rates have an inverse relationship and increase in interest rates thus affects the bond value negatively. Due to the fixed coupon rate and interest payments, fixed-income securities are highly sensitive to inflation rates as cashflows may lose value. There is also credit risk including potential default by the issuer. If an investor buys international bonds, she/he is always exposed to exchange risk due to the ever-fluctuating FX rates.
Thus it is essential for investors to take into account these factors and purchase fixed-income securities according to their individual requirements and risk appetite.
Amodeo K. (10/05/20201) Fixed Income Explanation, Types, and Impact on Economy The Balance.
Blackrock Education: What is fixed income investing?
Corporate Fiannce Institute: Fixed-income securities
About the author
The article was written by Jayati WALIA (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).