Fixed income securities are a type of debt instrument that provides returns in the form of regular, or fixed, interest payments and repayments of the principal when the security reaches maturity. The instruments are issued by governments, corporations, and other entities to finance their operations. They differ from equity, as they do not entail an ownership interest in a company, but they confer a seniority of claim, as compared to equity interests, in cases of bankruptcy or default.
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 are.
The borrower is willing to pay more interest in return for being able to borrow the money for a longer period 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."
Many examples of fixed income securities exist, such as bonds (both corporate and government), Treasury Bills, money market instruments, and asset-backed securities, and they operate as follows:
Bonds
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 (which generally occur 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.
Treasury Bills
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.
Money Market Instruments
Money market instruments include securities such as commercial paper, banker's acceptances, certificates of deposit (CD), and repurchase agreements ("repo"). Treasury bills are technically included in this category, but due to the fact that they are traded in such high volume, they have their own category here.
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
Risks of Investing in Fixed Income Securities
Principal risks associated with fixed income securities concern the borrower's vulnerability to defaulting on its debt. This risk is 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 for securities denominated in a currency other than the US dollar (such as foreign government bonds) and 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.
Related Readings
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