Finance of Fixed Income Securities

This article focuses on the relative advantages and disadvantages of fixed income securities, which are investments that provide a predictable rate of return over a specified period. As is discussed, fixed income securities include various types of government and corporate bonds, savings accounts, certificates of deposit, and preferred stocks. Fixed income securities are usually evaluated in terms of factors such as level of risk, rate of return, and the special features different types of securities offer. In general, fixed income securities are considered an important part of investment portfolios.

Keywords Agency Security; Annual Percentage Rate; Bond; Bond Fund; Bond Laddering; Callable Bonds; Certificate of Deposit; Compounded Interest; Corporate Bond; Debenture Bond; Fixed Income; Fixed Income Security; Interest; Investment Risk; Liquidity; Maturity; Municipal Bonds; Preferred Stocks; Principal; Savings Account; Security; Simple Interest; T-Bill; Treasury Inflation-Protected Securities (TIPS); Treasury Security; Volatility; Zero Coupon Bonds

Finance > The Finance of Fixed Income Securities

Overview

The money you earn comes from essentially two sources: salary from your job, and income from your investments. While a salary is almost always the same amount from month to month, how much money you earn from investments can vary, or, like a salary, it can be the same amount. In the latter scenario, your income is fixed-that is, the amount you earn doesn't change; you know what to expect each month. Investment earnings that stays the same on a regular basis are referred to as fixed income, and often come from investment securities-tradable instruments such as stocks and bonds that reflect an investor's ownership in, or debt obligations from, a company or government agency ("Definitions," 2007). Many investors prefer at least a part of their investment portfolios to be fixed because they can count on a certain amount of their income to be predictable and steady.

Fixed income securities-those investments which produce the same amount of money on a regular basis-have several advantages besides producing steady income. They often give conservative investors piece of mind, because, unlike stocks, their performance is characterized by low volatility. They also help diversify a portfolio by offering a steady, stable stream of revenue. Finally, many forms of fixed income securities provide tax advantages; in the case of many bonds, income from some sources may be exempt from Federal, state, and local taxes.

There are also disadvantages to holding fixed income securities (Fidelity Investments, 2007). For example, they may react negatively to an increase of interest rates, represent a credit risk if the company or agency has financial problems, or lose their value because of inflation over a long period of time. They may also be "called in" or redeemed early, if the issuer pays off its debt early, in which case the investor would not receive the expected amount of earnings. Finally, especially in the case of long-term investments in which money is obligated for many years, other more advantageous investment opportunities may be by-passed, which is referred to as reinvestment risk. Astute investors therefore must balance the pros and cons of fixed income securities as they clarify their investment goals and build their portfolios.

Applications

Types of Fixed-Income Securities

One of the most common types of fixed-income securities is a bond, or loan one entity makes to another. Bonds commonly offer fixed income in the form of Treasury Securities, Agency Securities, Corporate Bonds, and Municipal Bonds (U.S. Department of the Treasury, 2007).

Treasury Securities

Treasury securities are debt obligations issued by the U.S. Government. They are backed in "full faith" by the government, which means they are virtually risk-free (Fidelity Investments, 2007). A treasury security is a type of bond, or loan, made to the government, and earns interest over its period of ownership, which is usually several years. At the end of the specified period, the bond reaches maturity-the date at which the principal (the amount invested) is returned to the buyer. Treasury securities are known for their safety, tax advantages, and liquidity. Their downside is that they generally have lower rates of return than other types of more assertive investments. Savings bonds are also forms of treasury securities, as are T-Bills which are short-term government obligations.

Agency Securities

Agency securities are also relatively low-risk obligations that are issued by "agencies" or enterprises that the U.S. government supports. They are not fully backed by the government and are taxed differently. Because they are technically considered a greater risk than treasury securities, they typically earn higher interest. Examples of agency securities include mortgage-based investments sponsored by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac).

Municipal Bonds

Municipal Bonds (called "munis") are securities issued by local governments such as states or cities. Munis are typically exempt from Federal, state, and local taxes and are issued in denominations of $5,000. They are usually created to help fund public projects, such as new highways, school facilities, or hospitals (Securities and Exchange Commission, 2007). Depending on their purpose, the terms of these bonds can vary from several months to as long as 30 years. Munis are generally low-risk and low-yield but contribute an important aspect to an investor's portfolio.

Corporate Bonds

Corporate bonds work like municipal bonds, but the issuer is a private company rather than an agency of government. Unlike munis, which are usually offered over-the-counter in denominations of $5,000, corporate bonds are sold through exchanges and are sold in denominations of $1,000. Because they are not backed by the government like municipal bonds and treasury bonds, they are considered riskier and therefore produce a higher rate of return. They are also not backed by any agency of the U.S. government.

Other Types of Fixed-Income Securities

Although bonds, in their various forms, represent a major type of fixed-income security, there are other instruments that provide a steady, predictable stream of revenue. These include savings accounts, certificates of deposits, and preferred stocks.

Savings Accounts

The most basic type of investment, a savings account is essentially a loan a depositor makes to a financial institution. If the institution is insured by the Federal Deposit Insurance Commission (FDIC), the deposit is guaranteed safe by the government up to $100,000. Therefore, it is a considered a safe type of investment. However, while savings accounts provide regular income-usually credited to a depositor's account once a month based on an annual percentage rate, or APR-that yield is usually very low, usually below one percent. Thus, a savings account with $1,000 in it would earn less than $10 of interest a year. Savings accounts are also very liquid, i.e., the depositor can take all of the money out at any given time without a penalty or loss.

Certificates of Deposit

A certificate of deposit (CD) works in a way very similar to a savings account, with the primary difference being a specified term or period in which the institution may use the money. CDs can be issued for varying periods, including one month, three months, six months, one year, five years, or any other denomination of time in between. Because the commitment period of a CD is specified, unlike that of a regular savings account, the interest rates are higher; usually the longer the period, the higher the rate. Also protected by the government if issued by an FDIC-insured institution, CDs can pay simple interest or compounded interest. Simple interest is merely a promised rate of return based on an annual percentage rate: If you deposit $5,000 and the interest rate is 5%, you will earn $250 a year for the use of your money. Compounded interest uses each bit of interest earned as the basis for the next interest payment. In other words, that same $5,000 at a 5% compounded rate would produce approximately $256.36. However, holders of CDs who withdraw their funds before the date of the maturity will have to pay a penalty, which is usually a portion of the interest that becomes forfeited.

Preferred Stocks

Revenue from preferred stocks is also considered a form of fixed security income. Unlike bonds, stocks represent a portion of ownership in a company and provide dividends for the holders. However, obligations on preferred stocks must be met before holders of common stock can be paid. Also, should a company file bankruptcy, preferred stock holders are considered creditors and may be entitled to relief, whereas holders of common stock may have no such recourse. Like interest earned from savings accounts and CDs, dividends from preferred stocks are fully taxable.

Issues

Risk

Like any investments, fixed securities come with some level of risk (except for treasury securities, which are considered virtually risk-free). Corporate bonds, in particular, may be risky if the financial management of the company is weak. Bonds are rated by Moody's and by Standard and Poor's to give investors an idea of how safe an investment might be; both of these resources can be accessed online (See "Suggested Reading" below). Debenture bonds, which may have relatively high rates of return, can be particularly risky because they are "secured" only on the name and credibility of the issuing company-i.e., there is no collateral put forth to ensure investors of a safe return (Kapoor, Dlabay, & Hughes, 2007). However, companies with well-established names and histories may be good risks; conducting ample research in a company or fund is always recommended before making any type of investment.

Risk also comes in the form of inflation. If a security is held for a long period of time (some bonds are issued for 30 years), the profit from the interest can be "eroded" because the money will have less value when the bond matures than when it was issued. Such a loss can be offset to a certain degree if the bond produces tax-free interest and is less of a risk with short-term notes such as T-Bills.

Another form of risk exists among bonds that are "callable." Callable bond issuers may withdraw, or "call" the bonds before their maturity, especially if interest rates increase. When interest rates go up, the issuers can re-assign the bonds to commercial lending institutions and receive a greater return for their money (morgankeegan.com). Mortgage-based bonds are also susceptible to calls, if the mortgage holders re-finance their loans or pay them off early. While bond holders would not lose their principal, they would not receive the amount of interest they expected when they purchased the bond. This can also cause a "reinvestment risk," which occurs when the principal and interest may have to be re-invested at a potentially lower rate of return.

Special Features of Bonds

We have already discussed the basic types of fixed-income securities and their comparative advantages and disadvantages. Additionally, there are special types of securities that offer unique features that may be attractive to investors. These include zero coupon bonds, bond laddering, bond funds, and Treasury Inflation-Protected Securities (TIPS).

Zero Coupon Bonds

Zero coupon bonds are securities that are purchased at a fraction of their face value, or par value, and pay no interest until they mature (remember that most bonds pay interest while being held). When the bonds reach their maturity, the bond owner receives the full value of the bond, which has been earned through the interest accrued during the time of holding. Zero-coupon bonds tend to be more volatile than other forms of bonds and have a higher risk factor; the advantage is that they call for a small initial investment.

Bond Laddering

Bond laddering is a strategy involving the purchase of several bonds, each with different maturity dates. Bond laddering is used to diversify portfolios and to reduce risks related to inflation. For example, an investor buys a series of bonds, and as each matures, the principal and interest from that bond can be re-invested in other, more profitable securities. The advantages to bond laddering are liquidity and low call risk; the disadvantage is that the shorter-termed intervals will typically produce lower rates of return.

Bond Funds

Bond funds are groups of funds, managed by a professional financial manager, who takes investors' money collectively and buys a variety of different bonds, spreading the combined principal across different types of investments. Thus, the individual investor does not have to make specific investment decisions, can make a greater return because a larger amount of money is "pooled," and enjoy a wider diversification of their portfolio. Fees may be charged for the management of bond funds.

Treasury Inflation-Protected Securities

Treasury Inflation-Protected Securities (TIPS) were first issued by the U. S. Treasury Department in 1997. Their purpose was to attract investors whose goal was to avoid erosion of principal and interest because of inflation. TIPS are adjusted (with a three-month lag) for inflation-if inflation goes up, the investor's principal is increased; if deflation occurs, the amount of interest is reduced-but the principal can never be less than its original value (Smith-Barney, 2007). TIPS are based on the activities of the Consumer Price Index (CPI) and pay interest semi-annually (Smith Barney, 2007).

Conclusion

Fixed-income securities represent one type of investment that can play an important role in a portfolio. Compared to stocks, the advantages are safety, diversification, and, in the case of government securities, tax benefits. Their rates of return tend to be lower than riskier forms of investments, but they have the ultimate benefit of predictability-an investor knows how much money he or she will have at the end of a certain period.

Various types of bonds, as well as savings accounts, certificates of deposit, and preferred stock can also produce fixed incomes. These investment venues are regarded by many financial planners as a critical component of investment portfolios. They should also, however, be balanced with other forms of long-term planning, in accordance with the investor's goals, available resources, and level of risk aversion.

Terms & Concepts

Agency Security: Relatively low-risk obligations that are issued by "agencies" or enterprises that the U.S. government supports.

Annual Percentage Rate: The simple interest rate or percentage which invested money earns over a period of one year.

Bond: An obligation, or loan, made to a company or a government, which accrues a specific rate of interest over a specified period of time.

Bond Fund: A collection of bonds, managed by financial experts, who used "pooled" money from numerous investors to establish a diversified portfolio.

Bond Laddering: A financial strategy involving the purchase of different bonds which have different maturity dates.

Callable Bonds: Bonds that are redeemed by the issuer before their maturity date.

Certificate of Deposit: Savings certificate with a maturity date and specified interest rate issued by commercial banks; terms range from one month to five years.

Compounded Interest: Interest earned on principal plus already-accrued interest.

Corporate Bond: A debt security issued by a corporation.

Debenture Bond: A security issued on the basis on a company's financial reputation rather than on specified assets.

Fixed Income: Investment earnings that stay the same on a regular basis; referred to as fixed income.

Fixed Income Security: Investments which produce the same amount of money on a regular basis.

Interest: The cost of loaned money.

Investment Risk: Loss of income when an investment matures and is re-invested at a lower rate of return.

Liquidity: How easily a security can be bought and sold.

Maturity: The time at which an obligation is ended, a date specified at the time of issue.

Municipal Bonds: Securities issued by local governments such as states or cities.

Preferred Stocks: Shares of ownership in a company, the dividends for which must be paid before dividends are paid on common stock.

Principal: The amount of an initial investment upon which interest is earned.

Savings Account: Essentially a loan a depositor makes to a financial institution.

Security: Tradable instruments such as stocks and bonds that reflect an investor's ownership in, or debt obligations of, a company or government agency.

Simple Interest: The amount of money an investment earns over a period of time, expressed as a percentage rate of the principal.

T-Bill: A short term debt obligation by the U.S. government with a maturity date of usually less than one year, bought at less than par value.

Treasury Inflation-Protected Securities (TIPS): Government bonds that are adjusted for inflation.

Treasury Security: Debt obligations issued by the U.S. Government. They are backed in "full faith" by the government.

Volatility: The degree of fluctuation a security has over a period of time.

Zero Coupon Bonds: Securities that are purchased at a fraction of their face value, (par value) and pay no interest until they mature.

Bibliography

Costandinides, C., & Sinclair, L. (2013). Considerations when investing in and pricing emerging market fixed income securities. Journal of Securities Operations & Custody, 6, 31-41. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90589272&site=ehost-live

Definitions. (2007). Traders' log. Retrieved October 4, 2007, from http://www.traderslog.com.html

Dubil, R. (2013). Make callable bonds part of your fixed income allocation. Journal of Financial Planning, 26, 54-60. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86445559&site=ehost-live

Fidelity Investments. (2007). Why fixed income? Retrieved October 4, 2007, from Personalfidelity.com. http://personal.fidelity.com/products/fixedincome/fiwhyfixed.shtml

Fisher, D. (2013). Dodging disaster. Forbes, 191, 64. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89457923&site=ehost-live

Kapoor, J. R., Dlabay, L. R., & Hughes, R. J. (2007). Personal finance (8th ed.). New York: McGraw-Hill Irwin.

Morgan Keegan & Co., Inc. (2007). Bonds. Retrieved October 5, 2007, from MorganKeegan.com. http://www.morgankeegan.com/MK/investing/IProducts/fixedincome/default.htm.

Smith-Barney. (2007). U.S. treasury inflation indexed securities (TIPS). Retrieved October 5, 2007, from SmithBarney.com. http://www.smithbarney.com/pdf/tipsbrochure

U. S. Department of the Treasury. (n.d.). FAQ: Fixed income. Retrieved October 5, 2007, from http://www.treas.gov/education/faq/markets/fixedincomefaq.shtml.

U. S. Securities and Exchange Commission. (2005). Bonds, corporate. Retrieved October 4, 2007, from http://www.sec.gov/answers/bondcrp.htm.

Suggested Reading

Fabozzi, F. (2001). The handbook of fixed income securities (6th ed.). New York: McGraw Hill.

Lewis, J. (2007). GEAM shifts fixed-income focus. Investment Management Weekly, 20, 1-7. Retrieved October 10, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25776986&site=ehost-live

Martellini, L., Priaulet, P., & Priaulet, S. (2003). Fixed income securities: Valuation, risk management, and portfolio strategies. Hoboken, NJ: Wiley & Sons.

Sorondo, M. (2007). WSIB seeks two investment pros. Investment Management Weekly, 20, 4-5. Retrieved October 10, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25776994&site=ehost-live

White, J. & Meigs, R. (2007). Know when to hold 'em. Employee Benefit News, 21, 37. Retrieved October 10, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25813625&site=ehost-live