Fixed-income securities are investments that provide a known cash flow on a scheduled basis. The majority of fixed-income securities accomplish this by providing interest payments and repayment of the principal amount of the loan at maturity. However, fixed-income securities serve multiple purposes in addition to generating income and preserving capital. One of the primary functions of fixed-income securities is to help stabilize the overall risk within a portfolio. The term “fixed income,” however, does not refer to a single product. Rather, bonds, notes, bills, and preferred stocks are examples of fixed-income securities that can act in a very dissimilar manner during times of stress. Therefore, it is important to understand the underlying factors that drive the return on a particular fixed-income security as well as those factors that could potentially lead to a loss: interest rates, credit quality, time to maturity, and features of the security including callable provisions and inflation linked features.
1. Issuer Type and Credit Risk
The type of entity issuing the fixed-income security will affect the level of default risk associated with the security as well as the expected yield of the security. In general, issuers backed by the full faith and credit of a sovereign government will have lower credit risk than private company issuers, however, they typically will have lower interest rates.
Common issuer categories include:
- Sovereign government debt: Typically viewed as having low credit risk in a stable country.
- Municipal bonds: Issued by state or local governments; typically have tax advantages in certain jurisdictions.
- Corporate bonds: Issued by private companies; typically have higher yields to compensate for credit risk.
- Agency or supranational debt: Backed by a specific institution; credit risk depends on the structure of the security.
Credit quality is typically represented by a rating system (e.g., investment grade vs. high-yield). Lower-rated bonds typically offer a higher yield to compensate for the increased likelihood of default, however, they can experience significant declines in price during periods of increased market concern over default.
2. Maturity, Duration, and Interest Rate Sensitivity
Maturity represents the length of time until the principal of the security is repaid. Duration represents the approximate percent decrease in price per unit increase in the yield of the security. Longer maturities typically represent longer durations and can exhibit greater volatility.
A comparison of the characteristics of the various maturity types includes:
- Treasury Bills (Very Short-Term): Low interest rate sensitivity and lower yields.
- Notes (Medium Term): Moderate interest rate sensitivity and moderate yields.
- Bonds (Long-Term): Higher interest rate sensitivity and larger price movements.
When interest rates rise, the attractiveness of older bonds with lower coupons decreases resulting in lower prices. Conversely, when interest rates decline, the prices of bonds may increase. As a result, two bonds with the same credit rating may have very different risks.
3. Coupon Structure and Cash-Flow Predictability
The design of the coupon of a fixed-income security will impact both the timing of interest income and the reinvestment risk.
Examples of common coupon designs include:
- Fixed-Rate Coupons: Equal interest payments each period; easiest to predict.
- Floating-Rate Coupons: Payment amounts adjusted to a reference rate; less sensitive to rate increases.
- Zero-Coupon Bonds: No periodic interest payments; return generated by purchasing the security at a discount to par and receiving the par amount at maturity.
- Inflation Linked Bonds: Payment amounts adjusted to reflect changes in an inflation index; protect against declining purchasing power.
Fixed-Rate Bonds provide predictable interest income but may decline in value when interest rates rise. Floating-Rate Securities may maintain value better in a rising interest rate environment but may experience reduced interest income in a falling interest rate environment.
4. Embedded Features, Liquidity, and Tax Treatment
Some fixed-income securities contain embedded options that modify the cash flow characteristics when the cash flows occur. Other securities may have limited liquidity, making it difficult to buy or sell them quickly at a fair price. Finally, taxes may affect the actual return on investment.
Features and market factors to watch:
- Callable bonds: Issuer has option to repay the security prior to maturity (typically when interest rates decline); limit upside for investor.
- Putable bonds: Investor has option to redeem prior to maturity; may allow for reduced risk in uncertain markets.
- Convertible securities: May be converted into shares of common stock; add equity-like characteristics.
- Liquidity: Limited trading volume of a bond may result in wider bid/ask spreads and higher transaction costs.
- Taxes: Certain bonds may have different tax implications than other bonds, depending upon the jurisdiction.
As with other aspects of investing, the specifics of the security itself can be as important as the stated yield. For example, two bonds with the same coupon may have significantly different results due to embedded options and trading costs.
Conclusion
The primary distinctions among fixed-income securities relate to the issuer’s risk profile, the maturity and duration of the security, the coupon design of the security, and any embedded options. These characteristics affect how a security reacts to rate changes, credit events, inflation, and changes in market liquidity. To effectively compare bonds, investors need to examine the underlying drivers of price movement and cash flow timing in addition to the headline yield. Careful analysis of credit quality, duration, and structural characteristics of a bond will result in better investment decisions and fewer unpleasant surprises, particularly during times of changed market conditions and when previously “safe” income-producing instruments begin to behave in a manner inconsistent with their previous behavior.