Getting Started with Fixed Income Investments
Are you looking for short term or long term securities that will provide you with regular income? Consider fixed income investment securities that will provide you with a set income through regular interest payout till the time of maturity. Read further to understand the types of Fixed income investments and the risks associated with them.
What is a Fixed Income in Investment?
Fixed income investment refers to the securities that provide regular returns at a fixed rate of interest till maturity. Unlike equity shares, which do not provide regular cash flow to investors and their ROI can change with market conditions, these securities provide regular income. Fixed income investments include T-bills, Government bonds, Corporate bonds and so on. They are more secure than other securities present in the market as corporate bonds are backed by the company’s credit-worthiness and Government bonds are backed by the Government itself.
Common Sources of Fixed Income
T-Bill or treasury bill is a short-term government debt backed by the treasury department of a country and has a maturity of one year or less. T-bills are usually issued in denominations of $1,000 but can go anywhere upto $5 million. As these are government backed, they are secure and have low risk.
T-notes or treasury notes are Government-backed securities that have a maturity of 1 to 10 years. T-notes are available in two categories - competitive bids and non competitive bids. In competitive bids, the investor defines the desired yield with the risk factor and his bid may not be accepted. However, in non-competitive bids, the investor has to settle with what the Government offers.
A corporate bond is a debt security issued by a company to fulfill their capital needs. The investors are paid a fixed number of interest payments at fixed or variable interest rate. When the bond reaches its maturity, the payments stop and the initial investment is returned. Sometimes, the company’s physical assets may be used as collateral. They are issued in blocks of $1,000 face value.
Investors consider these bonds to be a safer source of investment, when compared to other securities, and add them to their portfolio in order to balance the risk associated. As corporate bonds are considered to be riskier than Government bonds, they offer a higher rate of interest.
For instance, a company plans to set up a new plant and iissue 5% bonds at $2,000 each, due in 5 years. You purchase 20 bonds for a total of $40,000 and receive $2,000 for 5 years. The company receives $40,000 and uses it to invest in the plant. At the time of maturity after 5 years, the company will pay back the initial invested amount of $40,000 along with $10,000 as interest.
Municipal bonds are issued by the local state government, municipality or a special purpose district (schools, colleges) to meet the capital expenditures. These expenditures may be related to the day-to-day obligations or to fund capital intensive projects. Generally, these bonds offer exemption from federal tax and are like normal bonds that are sold at a coupon payment and a lump sum payment is given out at maturity.
Risks and Benefits of Fixed Income Investments
There are many benefits of investing in fixed income investments. They are -
Fixed income investments provide a fixed income through interest rates till the time of maturity. Their maturity rate ranges from 90 days (T-bills) to 10-20 years (in case of bonds). Investors looking for long term regular income should invest in bonds with high interest rates.
Secure Returns Priority at the time of Liquidity:
If or when a company is in a situation of liquidation, the fixed investors are given priority over the other investors. In such a case, bond holders will be paid off first then the equity shareholders are paid off.
Fixed income instruments have a specified maturity date, when the amount will be paid back to the investors. It is decided when the securities are issued and the issuer is legally liable to honor the deal. If they fail to do so, they will be liable to the legal action if a complaint is filed by the investor.
However, there are a few aspects that may make fixed income investments unfavourable, such as -
Risk of Interest rate:
Fixed income investments are susceptible to interest rate risk. Such risk occurs when the interest rate in the market where the investor has invested rises. As the investor has invested in the market at a fixed rate, this will give him fixed returns till maturity even though he could get higher returns on the same securities. As the amount invested has been blocked, he cannot invest in new high paying securities.
If the economy’s condition deteriorates due to any internal or external factors, the value of the instrument will also decline in the secondary market. Along with this, there is also a decline in the position of the company he has invested in. If, in such a case, he tries to sell the instrument in the market before maturity, he will incur loss or may not be able to sell them at all.
Call risk refers to the provision wherein an issuer can repay the bond early - these are known as callable bonds. If the interest rates are low enough , the issuer can repay the bonds and save money. Along with this, he can also issue new bonds at lower interest rates. The investors receive their principal amount and can reinvest it in the similar bonds, but at a lower rate of interest. The investor’s return on investment will be lower and as will the interes. This is more dangerous for investors who are dependent on interest from bonds as a source of income.
Fixed income investments offer regular returns at low risk and are a great way to diversify your portfolio. They are a great addition to your investment portfolio, especially if you are seeking to pool in your retirement funds. However, not as fool-proof as you may want them to be, it is advised to carefully weigh the pros and cons before tying yourself in such instruments for the long-run.