Fixed income securities are debt instruments where investors essentially lend money to governments, corporations, or banks in exchange for regular interest payments. Upon maturity, the principal amount is returned to the investors. Unlike stocks, fixed income securities offer near-guaranteed returns and provide stability when the stock market conditions are uncertain.
There are different types of fixed income securities, like Government bonds, corporate bonds, CDs, CPs, and T-Bills, each having its own issuer, features, and maturity periods. Here, we’ll learn about the meaning, types, risks, advantages and disadvantages of fixed income securities.
What Are Fixed Income Securities?
As the name suggests, fixed income securities provide you with a regular ‘fixed’ income in the form of interest. These financial vehicles are basically loans that you provide to different entities like the government, corporations, or other financial institutions. On that loan, you earn a fixed interest over a period, upon the completion of which you are returned the principal amount.
One of the most common types of fixed income securities is bonds. These are debt instruments issued by the government and corporations to raise funds for various purposes. The issuing authority uses them as a way to borrow money from investors. When you invest in a bond, you are lending money to the issuer in exchange for regular interest payments until the bond matures. At the end of the tenure, the issuer will repay you the principal amount.
Some other fixed income securities examples include Treasury Bills, Certificates of Deposits, Cash Management Bills, Sovereign Gold Bonds, and State Development Loans. Each type has different features which we’ll get into later.
Fixed income securities are fundamentally different from other types of assets such as stocks. When you invest in a stock, you are purchasing a small part or ‘share’ of the company you are investing in. Your returns thus depend on how well the company performs. A fixed income security does not let you own any part of the financial institution you’re investing in, and its performance does not affect your returns.
You will receive a fixed income at predetermined intervals, regardless of the issuer’s performance, as long as the issuer meets its obligations. This predictability makes fixed income securities a more stable investment option compared to equities, which can fluctuate due to a number of factors like market conditions, company profits, policy changes, or geopolitical events.
How Fixed Income Securities Work
Here’s a structure that will help you understand how fixed income securities work:
- The financial entity issues the security – State/ Central Government, bank, or corporation, issues the fixed income security to raise funds for specific purposes, such as developing new infrastructure, expanding operations, meeting short-term cash flow requirements, managing debt, or financing R&D. Different fixed income securities have different interest payments, also known as coupon payments, face values, and maturities.
- Fixed interest payments start – The issuer of the security will pay you a fixed interest at predetermined intervals, which can be monthly, quarterly, semi-annually, or annually. Generally, most issuers make these coupon payments semi-annually. These payments are calculated based on the fixed rate and the face value (the amount you invested) of the security.
- Maturity – As the security completes its tenure, the issuer repays the principal amount to you, the investor.
Let’s understand the basics of fixed income securities with the help of an example. Suppose you want to invest in a long-term fixed-rate bond issued by the Government. When looking at your options, you’ll find maturities ranging from 5 years to even 40 years.
If you select a 10-year bond with a face value of Rs. 1,00,000 and a fixed semi-annual coupon rate of 5% in January 2025, you will receive fixed interest payments on the principal amount twice a year. These payments will continue for the entire duration of the bond’s 10-year tenure, until the bond matures in January 2035. At maturity, you will be returned the original principal amount.
This is just a basic outline that highlights how fixed income securities work. There are different types of fixed income securities, with different issuers, face values, coupon payments, agreements, and risks.
Benefits of Fixed Income Securities
1. Steady and Predictable Income
One of the major benefits of fixed income securities is that they offer regular payments, which is attractive to investors such as retired individuals wanting to generate income without worrying about stock market conditions.
2. Portfolio Diversification
Since fixed income securities are debt instruments, they can be used to balance risk in portfolios. Equities like stocks and equity mutual funds can be used to achieve higher growth and returns, but they come with greater risk. Fixed income securities, on the other hand, can provide you with stability and predictable returns, which makes them an ideal complement to equity investments. For example, when the stock market is volatile, consistent interest payments from fixed income securities like bonds can help lessen the losses in the equity portion of the portfolio.
3. Low-Risk Investments
Since the returns on these securities are fixed and untethered to the stock market, they are considered very low-risk investments. Some types of fixed income securities, like government bonds or G-Secs, are practically risk-free as they are backed by the nation itself. In fact, many key risk-adjusted returns such as the Sharpe and Sortino Ratios use the G-Sec rate as the risk-free return to benchmark against.
4. Capital Preservation
Due to their low-risk nature, conservative investors looking to preserve the value of their money can consider fixed income securities. They are also very useful for waiting for the right time to invest in stocks. For example, if you’re uncertain about the stock market’s volatility, you can park your money in debt-focused mutual funds until you feel that the stock market is in a favorable position for more aggressive investment.
While the above advantages of fixed income securities make them appealing, they also come with some downsides that every investor should consider. They do offer stable income, but the growth potential is limited. For investors seeking higher returns, such investments may not be ideal as equities comfortably outperform them over the long term.
Another significant disadvantage of fixed income securities is that they carry interest rate and inflation risks. This is most apparent in long-term bonds. For example, if you own a long-term bond paying 6% interest and market rates rise to 6.5%, your bond’s value will drop because new bonds offer better returns. Similarly, inflation risk can destroy your real returns if the inflation rate rises above your bond’s fixed interest rate. There is also the lingering possibility of the issuer defaulting on payments.
Types of Fixed Income Securities
Generally, we can divide various types of fixed income securities into two – Those that are issued by the State/ Central Government or the RBI, and those that are issued by other entities like corporations and banks. Fixed income securities offered by the Government are also known as G-Secs. With that said, let’s have a look at the kinds of fixed income securities an investor can buy:
1. Government Bonds
A Government bond is a type of dated G-Sec that is issued to raise funds for purposes like infrastructure development. Generally, their maturity period varies from 5 years to 40 years. These securities can carry a fixed rate or a floating rate which is paid on a semi-annual basis at face value. Government bonds are of various types, such as:
- Fixed-rate Bonds – These are the most common types of government bonds. Here, the coupon payments are fixed and paid out semi-annually over the bond’s life.
- Floating-rate Bonds – Unlike fixed-rate bonds, floating bonds don’t have a fixed coupon rate for the entire tenure. Instead, the rate is revised by the Government at regular intervals.
- Inflation-Indexed Bonds (IIBs) – The main goal of IIBs is to protect the principal amount and the interest earned from the effect of inflation. Interest payments are thus adjusted as per inflation indices like the Wholesale Price Index (WPI) or Consumer Price Index (CPI).
2. Corporate Bonds
Just as governments issue bonds for various projects, corporations can issue bonds to fund R&D, expand, and more. Credit risk for these bonds is also comparatively higher, which means that the issuer can default on making coupon payments or even repaying the principal.To offset this risk and make their bonds more attractive, companies offer higher returns compared to government bonds.
By issuing corporate bonds, companies can raise funds without selling shares and diluting ownership. However, unlike equity financing, companies are obligated to repay the debt to investors.
3. Certificates of Deposit (CDs)
CDs are short-term fixed income investments as their maturity ranges from 1 to 3 years. They are offered by Scheduled Commercial Banks (SCBs) and other all-India financial institutions selected by the RBI. They require a minimum investment of Rs. 1 lakh.
4. Commercial Papers (CPs)
CPs are also short-term fixed income securities with maturity ranging from 30 to 270 days and are issued by corporations and other financial institutions with high credit ratings. They are zero coupon investments, which means they are issued at a discount to their face value and redeemed at face value when the maturity is up. The return is the difference between the issue price and the face value. For example, a CP may be issued at Rs. 990 (discounted price) and redeemed at its face value of Rs. 1,000 upon maturity. Here, the investor earns a return of Rs. 10 at the time of maturity and no interest payments.
5. Treasury Bills (T-Bills)
T-bills are issued by the Government and work similarly to how Commercial Papers work. They are also short-term money market instruments with zero coupons which means interest is not paid regularly, rather the investment can be bought at a discounted price and redeemed at face value. Treasury bills come with three tenures – 91-day, 182-day, and 364-day T-Bills.
6. State Development Loans
SDLs are issued by State Governments and pay half-yearly interests on the face value of the loan over the tenure. Upon maturity, the principal amount is paid back to the investor.
7. Sovereign Gold Bonds (SGBs)
SGBs are fixed income securities offered by the Government. The price of SGB is linked to the prevalent market price of gold. These bonds are becoming popular amongst investors as they allow them to invest in gold without the need for physical ownership, and since they are backed by the government, they are considered a safe instrument.
Each SGB is issued in denominations of grams of gold. The minimum investment is 1 gram, which offers an annual interest rate of around 2.5% per annum, paid on a semi-annual basis. What’s more, is that the value of the bond increases as the price of gold rises, so when the bond matures, you’ll receive the value of gold in cash, based on the market price of gold at the time of maturity.
SGBs mature in 8 years, but the Government provides an option to exit after holding the bond for 5 years.
8. Debt Mutual Funds
While debt mutual funds are not exactly fixed income securities, they invest heavily in fixed income assets such as government bonds, corporate bonds, treasury bills, and commercial papers. They pool funds from multiple investors and the fund manager invests the fund in a diversified portfolio of debt instruments which minimises credit risk.
A key advantage they offer over other options is liquidity. Even short-term options like T-Bills have a minimum holding period of 91 days, whereas the units of a debt mutual fund can generally be redeemed whenever the market is open.
9. STRIPS
Separate Trading of Registered Interest and Principal of Securities or STRIPS, are also known as zero-coupon bonds. These instruments are created from Government securities where the coupon payments and the principal repayment at maturity are separated and sold as different securities.
Risks to Consider
Even though these instruments are counted among the safest investments, investing in fixed income securities is not completely free from risk. It’s important to understand these risks to effectively mitigate their impact on your portfolio.
- Interest Rate Risk
Among other factors, the set interest rates of fixed income securities depend on the general level of market interest rates. If you buy a long-term bond that returns 6% per annum but shortly after the interest rates rise and new bonds are issued at 7%, the value of your bond will decrease as it becomes less attractive compared to new bonds.
This is interest rate risk – the possibility of your investment losing value due to changes in interest rates. This is an inverse relationship, which means that if new bonds are issued at a lower rate, like 5% per annum, your 6% per annum bond will increase in value.
- Credit Risk
Since an investment in fixed income securities is essentially you loaning out your money to institutions, there is always an outside chance that the issuer of the security defaults on interest payments. You may receive your income late or not at all. There is even a tiny chance of losing the principal completely.
That’s why G-Secs are preferred by conservative investors as the chance of a sovereign nation defaulting is close to zero. For other entities like corporations, investors must look into the credit rating of the issuer before committing.
- Reinvestment Risk
When investors are looking to reinvest their interest payments or their principal, there is a possibility that those funds will be reinvested at a lower interest rate than the original investment. For example, if you hold a bond with a 5% coupon and interest rates drop to 4%, when the bond matures or you receive coupon payments, you’ll only be able to reinvest that money at 4%, and your returns will be lower.
- Inflation Risk
Inflation is also considered when setting the interest rate of a particular security. The goal is to make sure that the return on the security provides investors with a decent real return after accounting for inflation. If inflation turns out to be higher than expected, the real return on your fixed income investment will turn out to be lower than anticipated.
- Liquidity Risk
If investors need to quickly sell off their holdings, there’s a chance that they may not be able to get a fair price for them due to a lack of buyers or market inefficiency. This is referred to as liquidity risk. Instruments like debt mutual funds are highly liquid, which mitigates this risk to an extent.
You should consider meeting with a financial consultant to understand how these risks, particularly reinvestment and interest rate risk can impact your investment strategy and overall financial planning.
Conclusion
Fixed income securities are debt instruments where investors provide loans to governments and other financial institutions like corporations and banks in return for periodic interest payments (called coupons) and the return of the principal amount at maturity.
Some types of fixed income securities include government and corporate bonds, SGBs, STRIPS, T-Bills, CDs, and CPs. Their benefits include safety, steady income, and portfolio diversification. They are also great tools for investors looking to preserve their wealth.
G-Secs can be purchased directly from registered banks and from official sources like RBI Retail Direct and corporate debt instruments like CPs and bonds can be bought from respective corporations, financial institutions, brokers, or through investment service providers. While these vehicles are considered very safe, they aren’t entirely risk-free.
Risks related to rising and falling interest rates, inflation, reinvestment, and the creditworthiness of the issuer should be considered before investing. Debt mutual funds aren’t exactly considered traditional fixed income securities, but they invest heavily in them. Due to inherent diversification, professional management, and the liquidity they provide, many risks associated with such securities can be mitigated.
