Fixed Income Definition Securities Instruments Examples

What is Fixed Income?

In general, fixed income instruments are called bonds. These securities are categorized under debt financing. Governments and corporations use these instruments to raise capital. It is a low-risk and low-return security that allows investors to diversify and mitigate the risk of their investment portfolios.

Key Takeaways

Fixed income is a financial instrument that provides interest at a constant rate during the whole maturity period. Investors receive their principal sum at the end of the maturity period.In case of bankruptcy, fixed income investors are reimbursed before equity shareholders.The timely interest payments are referred to as coupon payments; the principal is called the face value, and the interest rate is called the coupon rate.

Fixed Income Explained

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Investors can receive a fixed income from debt financingDebt FinancingThe primary difference between debt and equity financing is when the company raises the capital by selling the debt instruments to the investors. In contrast, equity financing is a process in which the company presents the money by selling the company’s shares to the public.read more. Governments and corporations use fixed-income instruments to raise capital. Borrowers pay timely interest (monthly, quarterly, semi-annually) during the maturity period. The principal amount is paid upon maturity.

In general, fixed income securities or instruments are called bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more; timely interest paymentsInterest PaymentsInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more are called coupon payments, and the principal is referred to as the face value. The interest rate offered by the particular security is called the coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond’s face value by the bond’s issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more.

Investors use these instruments to diversify their portfolios—the associated risks are lower than equities. These investment options provide a source of regular fixed income. Based on their risk appetitesRisk AppetiteRisk appetite refers to the amount, rate, or percentage of risk that an individual or organization (as determined by the Board of Directors or management) is willing to accept in exchange for its plan, objectives, and innovation.read more, investors can choose between different bonds.

Fixed Income Instruments/Securities

Fixed Income Instruments offered by governments and corporates are as follows:

Bonds: They have specific coupon rates that vary between different bonds. For example, floating-rate bonds have a coupon rate linked to market rates like LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions.read more. On the other hand, Zero-Coupon BondsZero-Coupon BondsIn contrast to a typical coupon-bearing bond, a zero-coupon bond (also known as a Pure Discount Bond or Accrual Bond) is a bond that is issued at a discount to its par value and does not pay periodic interest. In other words, the annual implied interest payment is included into the face value of the bond, which is paid at maturity. As a result, this bond has only one return: the payment of the nominal value at maturity.read more, return interests along with the principal upon maturity.

Treasury Bills: They are issued by the central government. They offer very low interest due to the zero-risk feature. T-BillsT-BillsTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more mature within three, six, nine, or twelve months.

Treasury Inflation-Protected Securities: TIPS adjust their principal value based on inflation rates. They help maintain investors’ purchasing power—principal value is increased when inflation rises, and vice versa.

Treasury Notes: It is a debt security issued by the US government. It can be acquired via competitive and non-competitive bids. The security matures within two to ten years. It yields a fixed interest rate.

Asset-Backed Securities: It is a debt financing product—secured by collateral assets. Investors can receive fixed incomes by investing in loans, receivables, etc.

Fixed Income ETFs: Exchange-traded fundsExchange-traded FundsAn exchange-traded fund (ETF) is a security that contains many types of securities such as bonds, stocks, commodities, and so on, and that trades on the exchange like a stock, with the price fluctuating many times throughout the day when the exchange-traded fund is bought and sold on the exchange.read more replicate the underlying bond market index. These shares can be exchanged on stock exchanges.

Fixed Income Mutual Funds: They are debt fundsDebt FundsDebt fund are investments, such as a mutual fund, closed-end fund, ETF, or unit investment trust (UTI), that primarily invest in fixed-income instruments like bonds or other types of a debt security for returns.read more that ensure regular interest payments and capital appreciation returnsCapital Appreciation ReturnCapital appreciation refers to an increase in the market value of assets relative to their purchase price over a specified time period. Stocks, land, buildings, fixed assets, and other types of owned property are examples of assets.read more.

Certificate of Deposits: Investors deposit a lump sum amount with the credit union or bank for a specific period. In return, they receive a high-interest rate.

Valuation

The price of a bondPrice Of A BondThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more is the present valuePresent ValuePresent value factor is factor which is used to indicate the present value of cash to be received in future and is based on time value of money. This PV factor is a number which is always less than one and is calculated by one divided by one plus the rate of interest to the power, i.e. number of periods over which payments are to be made.read more of the future coupon payments and the present value of the principal (face value). The following formula is used for calculation:

Bond Price=∑ (Cn / 1+YTMn ) + (P/ (1+i)n)

Here,

Cn is the coupon payment in the maturity period;n is the maturity period;YTM is the yield to maturityYield To MaturityThe Yield Function in Excel is an in-built financial function to determine the yield on security or bond that pays interest periodically. It calculates bond yield by using the bond’s settlement value, maturity, rate, price, and bond redemption.read more;P is the principal value; andi is the interest rate or yield to maturity.

From the above bond pricing formula, we can infer that the price of bonds and interest rates have an inverse relationship. And thus, three scenarios arise:

Par Bond: The bond is sold at face value when the coupon rate and yield to maturity are the same.Discount Bond: When the coupon rate is less than the bond’s yield to maturity, discount bondsDiscount BondsA discount bond is one that is issued for less than its face value. It also refers to bonds whose coupon rates are lower than the market interest rate and thus trade for less than their face value in the secondary market.read more are sold below their face value.Premium Bond: Here, the bond’s coupon rate is higher than its yield to maturity. Thus, premium bondsPremium BondsA premium bond refers to a financial instrument that trades in the secondary market at a price exceeding its face value. This occurs when a bond’s coupon rate surpasses its prevailing market rate of interest. For instance, a bond with a face value (par value) of $750, trading at $780, will reflect that the bond is trading at a premium of $30 ($780-750).
read more are sold at premium prices (higher than the face value of the bond).

Examples

Let us look at some examples to understand the practical application of fixed income:

Example #1

Let us assume that a bond is issued with a face value of $1000. The coupon rate is 7% and is paid annually. Here, the yield to maturity is 7% per annum. The maturity period is three years, and the principal amount of $1000 will be repaid at maturity. Determine the bond price.

Solution:

Given:

Face Value = $1000Annual Coupon Rate = 7%Maturity Period = 3 yearsYield to Maturity = 7% p.a.

Annual Coupon Payment = $1000 × 7/100 = $70

Bond Price = [70/ (1 + 0.07)1] + [70/(1 + 0.07)2] + [70/(1 + 0.07)3] + [1000/(1 + 0.07)3]

Bond Price = 65.42 + 61.14 + 57.14 + 816.3 = $1000

Thus, this bond is selling ‘at par’, i.e., at its face value.

Example #2:

If the yield to maturity is 8% per annum, determine the bond price.

Bond Price = [70/ (1 + 0.08)1] + [70/ (1 + 0.08)2] + [70/ (1 + 0.08)3] + [1000/ (1 + 0.08)3]

Bond Price = 64.81 + 60.01 + 55.57 + 793.83 = $974.22

Hence, this bond is selling at a discount,’ i.e., at a price lower than its face value.

Example #3:

Find out the bond price if the yield to maturity is 6% per annum.

Bond Price = [70/(1 + 0.06) 1] + [70/(1 + 0.06) 2] + [70/(1 + 0.06) 3] + [1000/(1 + 0.06) 3]

Bond Price = 66.04 + 62.3 + 58.77 + 839.62 = $ 1026.73

Therefore, this bond is selling ‘at a premium’, i.e., at a price higher than its face value.

Risks

These securities are prone to the following uncertainties:

Call Risk: With callable bondsCallable BondsA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bond’s maturity. This right is exercised when the market interest rate falls.read more, issuers can call (repay) the bonds before the maturity date. If the interest rate decreases, the issuer buys it back. This way, investors’ overall returns are reduced.Liquidity risk: These securities are generally less liquid than equities, and an investor might have to sell at a lower price to free up capital.Credit Risk: Corporate bonds come with a higher degree of uncertainty. The issuer might fail to fulfill obligations either by not paying the due interest or by not having sufficient funds to repay the principal amount.

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