Fixed Income Securities

Introduction

Fixed income securities are those financial instruments that provide a fixed rate of return and are independent of the external conditions like fall in interest rates, stock market crash, etc. The buyer of these securities will know in advance the exact amount he is going to get on a specified date in the future. People who are risk-averse prefer to invest in these securities as they are not market-linked and the probability of default is very low. Fixed income securities are generally debt-based or can be equity-based with debt-like features.

 

Debt-based securities

Bonds

Bonds are the contractual agreements between the issuer and the buyer in which the issuer agrees to pay regular interest payments which are a certain percentage of the face value of the bond for a predefined time and after the investment time is over the bond matures at par value (face value). Issuers can be government or a private company. Government bonds are considered less risky as they carry a sovereign guarantee whereas bonds issued by corporates are considered risky so the return on them is also high. Types of bonds based on payout:

Zero-coupon bonds: These bonds do not pay regular interest payments (coupon payments), rather these are sold at a discount to the face value. The discount value is decided by the interest rates. They are also called Pure Discount and Deep discount bonds. E.g. Treasury bills etc. These bonds carry interest rate risk if a person wants to sell them before the maturity date because the price of the bond will fluctuate before maturity based on prevailing interest rates in the market. At maturity, the bond will mature at its par value. As these bonds are not paying any coupons so they also do not carry any reinvestment risk.

Plain Vanilla Bonds: These bonds pay regular interest payments (semiannual or annual) between the issuance date and maturity date. At maturity, the investor gets the final coupon payment and face value of the bond. The price of the bond is determined based on the interest rate and the time horizon until maturity. These bonds can be floating rate bonds or fixed-rate bonds. Fixed-rate bonds make the same periodic coupon payments and are independent of the market conditions whereas coupons from floating rate bonds are dependent on changing interest rates. These bonds carry reinvestment risk because the coupons received may not be reinvested at the same rate.

 

Government bonds

Central government issues zero-coupon bonds to raise money. They are of different types depending upon the time of maturity:

·        Treasury Bills: Short term securities which mature within one year. At present, the Government of India issues 91-day, 182 day, and 364-day T-Bills.

·        Treasury Notes: These are medium-term bonds with maturities between one and ten years.

·        Treasury Bonds: These are long term securities with 30 years of maturity. U.S Treasury issues these bonds and many countries invest in them.

 

Currency based Bonds

Investors like governments of developing countries, corporates, etc. prefer to invest in bonds of stable currencies because if a currency is volatile then there is a possibility that returns made from the bond are neutralized by the depreciation in the currency. There are Dual Currency Bonds pay coupon payments in one currency and the face value in another currency. There are some bonds that give investors the choice to choose the currency in which they want to receive interest and principal payments. Such bonds are called Currency option bonds.

 

 

Bank deposits

Banks need money to lend in order to earn profits. So, they raise money from individual investors by paying them a fixed rate of return which is higher than the savings account rate for a specified period of time. Interest rates depend on the horizon of investment. Shorter the time period, lower the rate. Types of fixed deposits:

Cumulative fixed deposit: In this scenario, the interest earned by the investor at regular intervals is not paid to him rather it is added back to the invested amount. This leads to the benefit of compounding. Finally, when FD matures the principal and interest are returned to the investor.

 

Regular payout deposit:  Here, interest earned on the invested amount is paid to the investor at regular intervals. Payouts can be in the form of monthly interest earned or quarterly interest earned. Finally, at maturity, the investor gets only the invested amount back.

 

Recurring Deposits

In the case of fixed deposits, the whole amount is invested in one shot for a definite period at a specified rate. When the same money is invested in equal installments at regular intervals like monthly installments then it becomes a recurring deposit (RD). This also resembles a systematic investment plan (SIP). Interest is calculated based on the amount that is already deposited in the RD account. RDs help small retail investors to build a big corpus of wealth over a period of time and also do not carry any reinvestment risk as the entire principal and interest incurred is paid at the end of investment time.

 

Rights linked to debt instruments

Common equity holders are at maximum risk in case the company fails but they also enjoy majority rights and have the capability to force the management to work towards shareholders’ interests. As bondholders are at minimum risk, so they have limited rights:

·        Right to receive the periodic interest payments till the maturity date and at maturity receive the face value of the bond.

·        First rights on the assets of the company in case the company goes bankrupt.

·        No voting rights so cannot influence the management of the company.

·        Right to receive the financial information of the company.

 

In the case of bank deposits, if a bank goes bust then the depositor is liable only for the insured amount on all his deposit accounts. In India, Deposit Insurance & Credit Guarantee Corporation (DICGC) provide insurance cover up to Rs. 5 lakhs on all types of deposits in a bank

 

Preferred Stock Options

Debt investments do not provide ownership in a company but their returns are fixed. Preferred stock options combine ownership with coupon payments. Owners of these stocks have higher claims on dividends than common stockholders. These dividends are fixed based on the benchmark interest rate at the time of issuing the stocks. One major drawback of this is that owners of these shares do not have voting rights. If due to financial distress, a company has to suspend its dividend payments then unlike bond interest payments, it is not considered as a default. The preferred stock owners have the right to receive dividends in the form of arrears before the dividend to common stockholders resumes. While claiming assets of a company, they are subordinate to bondholders but superior to common stockholders. Sometimes companies issue preferred stock because they are not allowed to issue more debt. With the approval of the board of directors, preferred stocks can be converted to common stocks. Some preferred stocks are callable means the issuer can purchase them back at the par value after a particular date. This is generally done when interest rates fall in order to save interest costs. After this, new stocks can be issued at lower interest rates.