Fixed Income Securities and Economics

A main purpose of this essay is to convey information relevant to the exchange of a specific type of debt instrument. Factors under consideration herein center on gains that may accrue whether a holder buys, sells, or keeps the instrument. With respect to exchanges of debt, timing may be everything and certainly some times are better for some actions than are other times. One feature is the relationships between security price and other financial market variables including interest rates. This essay focuses its attention mostly on risk-free bonds, which the federal government buys and sells on a daily basis and in cycles. Open market operations, as a monetary policy tool, are used on a daily basis often influencing domestic and global economies. The essay approaches the topic from a broad perspective, but it may yield benefits for those readers who want consider adding fixed income securities to their investment portfolio.

Keywords Bond Issue; Bonds; Coupon; Coupon Rate; Debt Instrument; Denominations; Equity; Fixed Income Securities; Interest Rate; Loans; Maturity; Monetary Policy; Open Market Operations; Par Value; Present Value; Risk-Free Bonds; Security; Stocks; Time Value of Money; Yield

Economics > Fixed Income Securities & Economics

Overview

This essay condenses the basic concepts regarding fixed income securities and applies them in a manner that is relevant to the reader. The essay targets undergraduate college students as readers who may benefit from an initial condensed summary on a specific type of a fixed income security; namely those securities issued by the federal government of the United States. Persons around the globe hold a significant portion of those securities. While the essay ultimately approaches the topic from a broad domestic macroeconomic perspective, its contents may be instrumental in helping readers reap some financial gain from their own investment activities.

As a concise introduction to the topic, the government securities referred to herein are virtually default free and they pay holders a fixed amount of income in the form of interest payments. Readers should note, however, several varieties of securities are available through the financial market, which consist of individuals who exchange quantities of debt instruments at given interest rates. The interest rate and some other key requirements regarding the exchange of funds are expressed in a variety of ways. A private borrowing agreement governs loans whereas a public agreement governs bonds. Loan transactions usually involve a few individuals such as the lender, the borrower, and perhaps a co-signer.

Bonds

Bond transactions however usually involve the public at large. Moreover, almost any bond sold is one from a set of bonds called a bond issue. The total amount of a bond issue may range in value from tens to hundreds of millions of dollars. An objective of a bond issuer is to borrow funds in large bundles from individual members of larger society. Bond issues may originate from corporations or local, state, or federal government agencies. A sequential process begins as bond issuers receive cash from each bond sold. Those who purchase a bond will receive interest payments on a regular basis until the date arrives at which the issuer returns cash to the buyer.

A security is a specialized form of bond. Nonetheless, readers will find them used interchangeably in the remainder of this essay. A house mortgage is one example of a bond secured through market value of the property and income of the borrower. While maintaining a clear distinction between loans and bonds, readers may find it convenient to think of a security as resembling a loan that has enough collateral to satisfy all the terms in an agreement. In brief, collateral effectively lessens the potential negative financial exposure faced by lenders or bond holders. Securities or bonds issued by the federal government are virtually a default-free and a risk-free loan given the expectation that the issuer will be fiscally solvent and perpetually functional beyond the foreseeable future and across a countless number of generations.

Stocks vs. Bonds

Another important distinction is appropriate at this point. It arises because references to stocks and bonds often give the appearance that they are interchangeable terms. Substantive distinctions exist between them though they share at least one common feature relevant to this essay. A stock involves taking equity or partial ownership in a company, which is exchanged on a daily basis in the stock market through sales and purchases. In contrast, as mentioned before, a bond resembles a loan. Typically, the bond holder owns only the debt it represents. On occasion, the issuer of corporate bonds will allow for their conversion into stocks, which means trading organization debt for organization equity or ownership. A far more common feature between stocks and bonds resides with the practice of purchasing them at the lowest price possible and then selling them at the highest price possible.

Generally, the expectation is that bonds act "primarily as a stabilizer" for portfolios; their role is to protect principal, "offer reasonable income with modest volatility, and serve as a diversifier of the more volatile equity allocation" (Co-published chapter: A different future for fixed income, 2013). Interestingly, between 2001 and 2011, a time during which "equities lost ground while bonds soared 9% a year" (Lim, 2011), "fear and greed worked together to send money pouring into bonds." Two-thirds of a trillion dollars flowed into bond mutual funds from the start of 2009 to the time of Lim's writing, in 2011, which represented more money than all stock funds attracted during the Internet bubble of 1998 to 2000 (Lim, 2011).

Fixed Income Securities

Basic Components

With the aforementioned distinctions and clarifications, we are now ready to examine fixed income securities in more detail. Fixed income securities contain three basic components according to Strumeyer (2005). This section describes those components and it provides a foundation for their application in a larger economic context.

• First is the coupon rate which specifies the security's interest payment.
• Second is maturity which specifies the security's term of investment.
• Last is the price or yield which specifies the security's market value.

Bond Pricing & Exchanges

The price of a bond generally reflects the time value of money, which means that a dollar today is worth more than a dollar tomorrow; conversely, a dollar received later is worth less than one in hand today. Furthermore, the present value of that dollar is likely to be less than its future value unless the loan period and the interest rate provide adequate compensation to the lender. Let us consider some additional terminology and basic mathematical calculations regarding bond pricing and exchanges.

Bonds are available in various denominations. An amount common to public issues of bonds is the $10,000 denomination. It represents the bond's face value, which by definition is the amount borrowed or the principal amount. In essence, individual members of the public can purchase the bond by providing $10,000 in cash to the bond issuer. By doing so, the issuer promises to return that sum of cash at a later point in time and to pay interest on that cash between now and then. Repayment of the $10,000 will occur on a specific date in the future, which by definition is the bond's maturity date. More precisely, payments of the principal amount and the last interest payment occur at maturity, but the bond holder receives interest payments every six months during that investment period. The amount of interest paid on an annual basis to the bond holder is by definition a form of fixed income.

Issuance & Purchase of Bonds

Consider now what happens over time with the issuance and purchase of bonds. Let us begin by examining the hypothetical case of a bond bought on this date last year for $10,000. It promises to pay the purchaser or holder $1,000 per year in interest until maturity. By definition, the income payment on a bond is a coupon and the interest rate for a bond is its coupon rate. Exactly one year later, the issuance of another $10,000 bond contains an $800 coupon. In a basic sense, interest rates declined over the year from 10 percent ($1,000/$10,000) to 8 percent ($800/$10,000).

Next readers face the question: If the holder wants to sell the bond bought last year, what price is it likely to receive today? Armed with the general knowledge that an inverse relationship exists between bond prices and interest rates, we will find the bond fetching a price higher than the original amount. Now, let's do the math. The annual promise is $1,000 and the current interest rate is 8 percent. We expect the price of the older bond to be around $12,500, which is the result from dividing the promise amount by the current interest rate ($1,000/0.08). Publication of the price at which a bond sells at maturity is in the form of a ratio per $1,000 of the denomination or face value; by definition this is its par value. The aforementioned bond sold with a par value of 1.250 ($12,500/$10,000).

Rate of Return

Bond market conditions change and sometimes traders pay higher prices for bonds. In general, this affects the yield, which by definition is a rate of return measure, because the par and coupon rates are fixed. Yields change over time with market conditions and investors can use them to estimate the expected rate of return. Specifically, an increase in a bond's price, which is determined within the financial market, reduces a bond's yield. Note that the calculation of yield involves estimating the present values of benefits and of costs and setting the net present value to zero.

A few commitments of terms and relationships to memory may help investors know when to sell and/or to buy bonds, fixed income securities, and the like. Perhaps more important is gauging what happens, or what one expects to occur, between the instrument purchase point and its sale point. In essence, the rate of return for the holding period is the result of two opposing influences. On the one hand, a decrease (increase) in financial market interest rates affects the rate of return and it increases (decreases) price. On the other hand, an increase in price also affects the rate of return but it generates capital gains. Readers may begin to appreciate the complexities associated with decisions of whether to buy or sell debt instruments and whether to opt for holding onto their cash. All told, considering the opportunity cost for a bond requires taking into account various factors including risk comparability. The terms from above provide a foundation for examining possible decisions that bond holders face and for applying them in a variety of ways.

Applications

Some financial gain may accrue to the holder whether the bond is sold or it is kept. First, the holder is likely to receive a greater amount of interest than possible if the funds were to remain in a savings account. Second, the return is likely to be greater than the expected annual rate of inflation, which usually hovers around three percent. Third, the holder is currently in a position to sell the bond at a price higher than its purchase. In brief, a decline in interest rates since the bond's purchase signifies an increase in its price. Much like most other commercial exchanges, a key objective is to buy when the price is as low as one would expect and to contemplate its sale when the price is as high as one would expect.

A Key Relationship: Risk & Return

As a minor point of departure considering this essay's treatment of risk-free bonds, let's enter risk into the calculus for a brief moment before directing attention toward additional aspects of those bonds. A general positive or direct relationship is common in matters of economics and finance: A low (high) risk translates into a low (high) return and/or a low (high) interest rate; in the banking industry, for example, lenders charge low-risk borrowers a low rate of interest. Readers should be aware that bonds or securities omitted from this essay may vary in the amount of actual or potential risk and in the sources of risk. More precisely, risk is an expression of the likelihood that the issuer will abandon the agreement and/or cease to make timely payments.

Assessing Risk

The issue of risk seems to beg the question: How does one assess the degree of risk? On the conceptual side of this assessment matter, one valid, reliable, and simple method is to compare a default-free minimal-risk bond such as a government security to another type of fixed income security on their interest or coupon rates. The difference between the rates is a good rough estimate of the amount of risk attached to the investment. If the coupon rate on a government bond is 10 percent and it is 20 percent on a corporate bond, then one may conclude that the risk approximates 10 percent. Certainly, risk and uncertainty are items for consideration in contemplating what markets may present for corporate operations and the quality of the corporation's credit; they are beyond the scope of this essay, but they are topics that a prospective buyer needs to examine and understand. On the practical side of the matter, most issuers obtain ratings for their bonds from independent sources. Various rating schemes are expressed and found in books and other publications.

With a basic knowledge of fundamentals regarding bonds and especially fixed income securities, it is time to shift reader attention to the larger context of security exchanges and their possible effects on the state of a domestic economy. Those exchanges are also relevant to the global economy because individuals who reside in other countries own a significant portion of debt issued by the government of the United States. For instance, foreign entities hold more than one-third of that debt in terms of their total dollar value (Guell, 2007). This fact alone highlights the public context and global nature of security exchanges. As topics beyond this essay's immediate scope and depth, readers again receive encouragement to consult various publications on international trade, macroeconomics, and money and banking; they are rich sources of information about the complex interrelationships among interest rates, foreign exchange rates, and a host of other factors.

Authors of introductory textbooks in economics (Arnold, 200n; Guell, 2007; McConnell & Brue) point out that, in the broadest sense possible, the federal government occasionally borrows internally from a few of its affiliated agencies. Beginning with the next section, the remainder of this essay elaborates on some mechanics of those actions. As a preface to those elaborations, readers need to keep in mind that the benefits of most actions usually accrue long after the initial expenditures. In any given year, the expenditures of the federal government will likely exceed its tax revenues thereby generating a need to find ways to finance its budgetary deficits; infrequently, there is a budgetary surplus. By the way, the US national debt is an accumulation over time of federal government budget deficits and surpluses.

Governmental Budgets & Debt Exchange Methods

The federal government buys and sells fixed income securities in a series of ongoing cycles. In the first cycle, the government collects cash as a result from their sales of securities to the public and deposits it with the U.S. Department of Treasury. Those members of the public who purchase them in effect become debt owners or bond holders. In a subsequent cycle, these holders will present them for cash as the securities mature. The federal government becomes the owner of those securities as it provides cash in return for them. The primary source of that cash is the U.S. Treasury because it buys them at maturity. In short, the federal government sells the debt it owns to the public via transfers to the treasury.

These transfer and exchanges are part of an even larger chain of daily events as dollars trade hands and cycle through the economy in the form of bank deposits and withdrawals. The Federal Reserve Bank conducts operations on a daily basis in which it coordinates publicly the sales and the purchases of securities. As the reader will discover in the forthcoming subsections of this essay, those operations partially determine and alter the nation's supply of money and the financial market's rate of interest. Before we enter those discussions, readers will receive an introduction of how the federal government borrows from itself.

The federal government can avoid direct engagement in the financial market by accessing the revenue collections of some of its agencies. The revenues of those agencies usually exceed their expenditures. Their net revenues originate through payroll taxes such as Social Security and Medicare and through the operations of the Postal Service. In brief, they hold funds that other agencies within the federal government can borrow; a major ongoing debate surrounds the issue of what will happen when the Social Security Administration's surpluses begin to disappear around 2010 as a large segment of the nation's population retires and begins to collect retirement benefits. From a historical perspective, casting the current debate aside, those funds allowed the government to borrow fewer dollars directly from the public via bond issuances.

Open Market Operations: Money Supply & Interest Rate Dynamics

Open market operations entails the buying and selling of government securities. Conducted on a daily basis, it is one of the tools of federal monetary policy and it often influences market interest rates. As we move toward closure of this essay, here's a brief synopsis of how that entire process unfolds. On the one hand, a security sale means that buyers pay cash by withdrawing funds from their own bank accounts. Cash withdrawals act to reduce bank balances and the amount of money that banks can loan to businesses and to households. Consequently, there is a reduction in the amount of cash in circulation and the supply of money within the economy. In effect, that supply reduction drives interest rates upward. On the other hand, a security purchase means that debt instrument holders sell them and receive cash. The effects are in reverse of those mentioned above. Cash receipts act to increase bank balances and the money supply, driving interest rates downward.

Conclusion

This essay condenses the basic concepts regarding fixed income securities and applies them in a manner that is appealing to varied audiences. It targets undergraduate college students as readers who can gain some ground by examining a specific type of a fixed income security. The focal point is those securities issued by the federal government of the United States. It is interesting that persons residing in other countries all around the globe choose to hold these securities. In conclusion, the essay approaches the topic from a broad perspective and it may prove useful in helping some readers reap more financial gain from their own investments. Indeed, the few years leading up to 2013 saw dramatic shifts in investment flows from equity into fixed income, with fixed income viewed as a safe bet (Dubil, 2013). Ken Taubes, head of investment management U.S. at Pioneer Global Asset Management SpA as of 2013, agrees, stating, "Tepid economic growth over the past few years coupled with volatile equity markets has driven many investors to the perceived safe haven of fixed income" (Co-published chapter: A different future for fixed income, 2013).

Terms & Concepts

Bonds: Instruments of debt issued by governmental or corporate entities in borrowing from public sources.

Bond Issue: The act of offering a large set of bonds for sale to the public; the main source of bonds available for individual purchase.

Coupon: The amount of the annual interest payment that a debt instrument promises.

Coupon Rate: The rate of interest applied in calculating the coupon payment amount.

Denominations: Face value of the debt instrument.

Equity: Ownership in a company often represented by the value of a stock.

Fixed Income Securities: A debt instrument that presents holders with annual payments of interest in constant amounts over a fixed term.

Interest Rate: The price of borrowing money expressed in an annual percentage.

Loans: A private version of borrowing that involves very few parties.

Maturity: The date at which principal and last coupon payment are paid on a debt instrument.

Par Value: A ratio expressing the price of a sold bond per $1,000 of its denomination.

Present Value: Current value of a future stream of income payments; calculated by dividing future value by a term-specific compounded interest rate.

Security: A debt instrument when backed by collateral to assure compliance with promises.

Stocks: A form of partial ownership or equity in the issuing entity.

Time Value of Money: A dollar today is worth more than a dollar tomorrow or a dollar received later is worth less than one in hand today.

Yield: The rate of return expected through or realized from a security or bond.

Bibliography

Arnold, R.A. (2005). Economics (7th ed.) Mason, OH: Thomson South-Western.

Choudhury, M. (2005). Fixed-income securities and derivatives. Princeton: NJ: Bloomberg Press.

Co-published chapter: A different future for fixed income. (2013). Asian Investor, 1. Retrieved November 22, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90616665&site=ehost-live

Dubil, R. (2013). Make callable bonds part of your fixed income allocation. Journal of Financial Planning, 26, 54-60. Retrieved November 22, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=86445559&site=ehost-live

Guell, R. C. (2007). Issues in economics today (3rd ed.). Boston, MA: McGraw-Hill Irwin.

Lim, P.J. (2011). Stop gobbling up bonds. Money, 40, 118?128. Retrieved November 22, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=57226845&site=ehost-live

McConnell, C. R. & Brue, S. L. (2008). Economics (17th ed.). Boston, MA: McGraw-Hill Irwin.

Strumeyer, G. (2005). Investing in fixed income securities. Hoboken: NJ: John Wiley & Sons, Inc.

Suggested Reading

Clarke, R., de Silva, H., & Murdock, R. (2005). A factor approach to asset allocation. Journal of Portfolio Management, 32, 10-21. Retrieved October 12, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=21880057&site=ehost-live

Fabozzi, F. J. (2007). Fixed income analysis. Hoboken: NJ: John Wiley & Sons, Inc.

Herold, U., Maurer, R., & Purschaker, N. (2005). Total return fixed-income portfolio management. Journal of Portfolio Management, 31, 32-43. Retrieved October 12, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=16975630&site=ehost-live

Johnson, R., Zuber, R., & Gandar, J. (2006). Binomial pricing of fixed-income securities for increasing and decreasing interest rate cases. Applied Financial Economics, 16, 1029-1046. Retrieved October 12, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=22483109&site=ehost-live

Schellhorn, C., & Lushbough, S. (2005). Managing the maturity of fixed-income investments in rising interest-rate environments. Journal of Financial Planning, 18, 62-68. Retrieved October 12, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=17857447&site=ehost-live