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 bonds, timely interest payments are called coupon payments, the principal is called the face value, and the interest rate that security carries is called 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 rate bonds – the coupon rate 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 makes principal as well interest payment together at maturity.
Pricing of Fixed Income Securities
- 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 maturity (interest rate) are the same. The bond will sell at its face value.
- Discount bond – when the coupon rate is less than the yield to maturity 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 price 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).
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 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 discount’i.e. at a price lower than its face value.
#3 – Interest rate (say 6%) is higher than 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 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 fixed 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 depend on the market interest rates and if sold in favorable market conditions, F.I. securities can provide capital appreciation return 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 hold always, but over a long period of time, equities provide higher returns.
- Fixed income instruments 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 payment at maturity and default on its obligations.
- Interest rate risk – the price of fixed 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 bond 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 increase, 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 appetite. 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 –