FIXED INCOME PRODUCTS
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 provide returns in the form of regular interest payments and repayments of the principal when the security reaches maturity.
Fixed-income securities are distinct from equities, or stocks, in that they do not represent an ownership interest in a corporation but instead grant equity investors seniority of claim in the event of bankruptcy or failure.
Governments, businesses, and other organizations issue the instruments to fund their operations. Fixed-income securities are purchased by investors as a means of diversification from equities and other asset classes and as a source of predictable cash flow.
How Fixed Income Works?
The interest payments that an investor receives, which are determined by the borrower's creditworthiness and current interest rates, are referred to as fixed income.
Bonds and other fixed-income assets typically pay greater coupons, or interest, as their maturities lengthen. This is because investors expect greater interest rates to commit their funds to investments for longer periods of time, while borrowers are willing to pay more interest in exchange for the ability to borrow money for longer periods of time. The borrower repays the borrowed funds, also referred to as the principle or "par value," at the end of the security's period or maturity.
Examples of Fixed Income Securities?
The most typical form of a fixed-income security is a bond, which can be issued by both private and public sector organizations. Other types of fixed-income securities include money market instruments, asset-backed securities, preferred securities, and derivatives.
By itself, the subject of bonds constitutes a whole field of financial or investment study. They can be broadly characterized as loans made by investors to an issuer with the promise of principal repayment at the specified maturity date and recurring coupon payments (often made every six months), which reflect interest on the loan. The reasons for these loans can vary greatly. Governments or businesses who are searching for methods to finance initiatives or operations frequently issue bonds.
2. Financial instruments
Commercial paper, banker's acceptances, certificates of deposit (CD), repurchase agreements (repo), and US Government Treasury Bills, more commonly referred to as T-bills, are among the products that make up the money market.
Treasury bills, which are issued by the US federal government, are thought to be the safest short-term debt instrument. These securities typically have 28, 91, and 182-day (one month, three months, and six months) maturities, with maturities ranging from one to twelve months. There are no ongoing interest or coupon payments with these securities.
3. Asset-Backed Securities (ABS)
Fixed income instruments known as asset-backed securities (ABS) are secured by "securitized" financial assets like credit card receivables, auto loans, and home equity loans. The ABS stands for a group of these assets that have been bundled into a single fixed-income instrument. Asset-backed securities are typically an alternative to corporate debt for investors.
4. Preferreds
These fixed-income securities, often known as subordinated debt, are lower on the capital stack. If the issuer's trustworthiness declines, preferred fixed-income instruments may stop paying their coupons or principal. Preferreds are frequently seen as a hybrid asset between fixed income and equities because of the risk known as loss absorption.
5. Derivatives
There have been numerous financial contracts in the capital markets with varying payoffs based on the behavior of other securities. These are referred to as "Derivatives," and in fixed income, we see these derivatives extensively traded for speculating, hedging, and gaining access to additional assets or markets. Examples of derivatives include swaps, options, and structured products.
Who Invests In Fixed Income Securities?
Institutional Investors and Retail Investors both invest in Fixed Income Securities. Each one of these types of investors has different considerations when investing in fixed income though.
Some of these considerations might be:
1. Liquidity:
Fixed Income Securities are among the most liquid investment classes, with 24-hour trading in most currencies.
2. Diversification:
Bonds can be used for portfolio diversification or to seek out safer investments, such as government bonds, commonly referred to as the "flight to quality."
3. Matching Investor Liabilities:
Fixed Income Securities offer a simpler solution for investors that need cash flow certainty, like pension funds or retirees, to manage their income and meet their responsibilities.
Risk of Investing in Fixed-Income Securities:
Investors in fixed-income securities often run the following four significant risks:
1. Inflation - The overall rise in price levels over a period of time is referred to as inflation. Since Fixed Income Securities often have longer lifespans and the majority do not have an adjustment to account for inflation, rising price levels reduce the purchasing power of their income flows, posing a danger to investors.
2. Interest Rate Risk - The risk that changes in interest rates could lower the market price of a fixed-income instrument that an investor owns is known as interest-rate risk. For instance, if an investor has a 10-year bond paying 3% interest and interest rates subsequently rise and new 10-year bonds are issued offering 4% interest, the investor's bond, which pays just 3% interest, loses value, and its price drops.
3. Default Risk - The main risk posed by fixed-income securities relates to the potential debt default of the borrower. These risks are reflected in the interest rate or coupon that the asset offers, with greater interest rates being offered to investors by securities with larger default risk.
4. Additional Risk - If investors purchase assets with foreign currency-denominated values, they also run the risk of exchange rate fluctuations as well as capital controls, which could prevent them from getting their money back.
Author ~ Himanshu Rane (PGDM - Finance)
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