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Fixed Income Securities: Types, Examples, Risks, and Benefits

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 Fixed Income Securities: Types, Examples, Risks, and Benefits
S.M. Ikhtiar Alam, Ph.D.
Professor of Business & Economics, Institute of Business Administration,
Jahangirnagar University, Bangladesh.

Corresponding Author: ikhtiar@juniv.edu

I. What are Fixed Income Securities?

Fixed income securities are types of debt instruments that provide returns in
the form of regular and/or fixed interest payments and repayments of the
principals when the security reaches maturity. These instruments are issued
by governments, corporations, and other entities to finance their operations.
They are not equity, as they do not entail an ownership interest in a company,
but they confer seniority of claim compared to equity in cases of bankruptcy or
default. This paper discusses various types of fixed income securities and risks
involved vis-à-vis the benefits.

II. How Do Fixed Income Securities 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.”
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III. Examples of Fixed Income Securities

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:

1. Debt Mutual Funds

Debt Mutual funds pool in resources from investors and invest the corpus
primarily in various debt instruments such as bonds, fixed income securities,
etc. Investment in these instruments ensures fixed returns for the investor.
Also, these funds invest in debt securities with good credit ratings. The
chances of default of payment on these securities are miniscule.

Compared to equity-oriented mutual funds, debt funds are relatively less

risky, therefore perfectly suitable for risk averse investors.

2. Bonds

Bonds are fixed income securities that are issued by corporations and the
government, to raise money for business expansion or financing new projects.
They are issued at a discounted price on their face value and can be traded in
the secondary market. Thus, an investor earns guaranteed profit, as the bonds
are redeemed at the face value upon maturity.

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,
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but due to the fact that they are traded in such high volume, they have their
own category here.

3. 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.

4. Bank Fixed Deposits (FD)

Bank fixed deposits are one of the most popular investment options available
in India. A fixed deposit account essentially offers fixed interest rate on your
principal investment. This fixed-income security is offered by almost every
scheduled bank in India. Numerous investors in India have availed the benefits
of Bank FD.

An investor makes a lump-sum principal investment that earns interest during

the deposit period. At maturity, the investor gets the principal and the accrued
interest.
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Different banks provide fixed deposit accounts with different maturities.

Investors can opt for FD accounts with maturity period ranging from 7 days
to 10 years.

5. Recurring Deposits

Recurring deposits are similar to SIP Investment in Mutual funds. An individual

deposits a small amount of money as a monthly installment for a fixed
duration that ranges from 1 year to 10 years in a recurring deposit. The
interest rate is the same as that of fixed deposits. This enables retail investors
with small amounts of money to generate a good corpus of wealth in the long
run.

6. Repurchase Agreements

Also known as repos or buybacks, Repurchase Agreements are a formal

agreement between two parties, where one party sells a security to another,
with the promise of buying it back at a later date from the buyer. It is also
called a Sell-Buy transaction.

The seller buys the security at a predetermined time and amount which also
includes the interest rate at which the buyer agreed to buy the security. The
interest rate charged by the buyer for agreeing to buy the security is called
Repo rate. Repos come-in handy when the seller needs funds for short-term,
s/he can just sell the securities and get the funds to dispose. The buyer gets
an opportunity to earn decent returns on the invested money.

7. Banker’s Acceptance

A financial instrument produced by an individual or a corporation, in the name

of the bank is known as Banker’s Acceptance. It requires the issuer to pay the
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instrument holder a specified amount on a predetermined date, which ranges

from 30 to 180 days, starting from the date of issue of the instrument. It is a
secure financial instrument as the payment is guaranteed by a commercial
bank.

Banker’s Acceptance is issued at a discounted price, and the actual price is

paid to the holder at maturity. The difference between the two is the profit
made by the investor.

8. 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.

IV. Why Invest in Fixed Income Securities?

If your financial goals involve earning steady returns coupled with low risk,
fixed income securities are the best investment option available in the market.
Compared to investment in equities, returns from these securities might be
low but they are guaranteed.

If you’re an active investor, investment in fixed income securities will diversify

your portfolio and yield returns even during turbulent market swings. This
reduces the overall risk of the investment portfolio.
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Some of the fixed income securities in India have tax saving options available,
which serves as another incentive for investment in these securities.

V. Risks of Investing in Fixed Income Securities

1. Principal Risks/Credit Risk

Principal risks associated with fixed-income securities concern the borrower’s

vulnerability to defaulting on its debt. Such risks are incorporated in the
interest or coupon that the security offers, with securities with a higher risk of
default offering higher interest rates to investors. In other words, credit risk
arises when the issuer of the bond or debt security defaults on the timely
payments of interest and/or the principal amount.

2. Interest Rate Risk

Changes in interest rates affect the bond prices, and consequently the returns
from debt mutual funds. If the interest rates rise, bond prices fall and vice
versa. This is known as interest rate risk.

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.

3. Currency Risk/Exchange Rate Risk

Additional risks include exchange rate risk or currency risk for securities
denominated in a currency other than the US dollar (such as foreign
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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. In other words, currency risk, or exchange rate risk, refers to the
exposure faced by investors or companies that operate across different
countries, in regard to unpredictable gains or losses due to changes in the
value of one currency in relation to another currency.

It is important to note that currency risk always has two components:

Transaction Risk and Translation Risk.

VI. Benefits of Investing in Fixed Income Securities

1.Stable Returns

One of the primary benefits of investing in fixed income securities is the

stability of returns that they offer. Since these instruments have a fixed
interest rate, the returns delivered by them are more or less steady. This
makes them a comparable alternative to bank savings accounts which give a
minimal interest rate on your deposits.

2. Safety of Investment

The invested capital in a fixed income security is at lower risk when compared
to investment in equities. As some of these instruments, such as treasury bills
or government bonds, are backed by the government, the chances of
defaulting on the payment of interest and principal is almost zero. Also, if the
instrument is highly rated by the credit rating agencies such as CRISIL, the
possibility of an investor incurring a loss is minuscule. This makes fixed income
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financial instruments, one of the safest investment avenues available in the

market.

3. Portfolio Diversification

Investment in fixed income securities offer a much-needed diversification to

a concentrated portfolio of equities. It is a well-known fact that equities deliver
much higher returns than debt securities, however the volatility of returns
delivered by the former is much higher than that of the latter. To make your
overall portfolio returns stable, it is imperative that you make a significant
investment in highly rated debt securities.

4. Priority during Liquidation

When the company files for bankruptcy and goes for liquidation, it is liable to
pay back to its debtors and stock holders. However, it might not have enough
assets to pay off both. In that case, lenders of the company, who hold
corporate bonds of the firm get priority over those who hold equity. This is
one more reason why debt securities are considered to be a safe investment
avenue.

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