Fixed-Income Securities are investments that generate a consistent cash flow based on a predetermined schedule. Most fixed-income securities achieve this through regular interest payments and the payment of the initial loan principal at maturity. While the generation of income and preservation of capital are major objectives of fixed-income securities, these securities also serve additional roles such as reducing the total risk within a portfolio.
The term “fixed income”, therefore, does not refer to a single product. Examples of fixed-income securities include bonds, notes, bills and preferred stocks. Due to the fact that fixed-income securities can act in a very dissimilar way during periods of economic stress, understanding the underlying factors that contribute to a particular fixed-income security’s returns as well as the potential risk factors that could result in a loss of money are critical: interest rates, credit quality, time to maturity, and the unique characteristics of the security, including callable provisions and inflation linked features.
1. Credit Quality of Issuer and Default Risk
The type of entity issuing a fixed-income security affects the degree of default risk as well as the anticipated yield associated with the security. Generally speaking, the credit risk of a sovereign government-backed issuer will be less than that of a private company issuer; however, the latter will generally have a lower interest rate.
There are several common issuer classifications:
Sovereign Government Debt: Typically regarded as being of low credit risk in countries with a stable economy.
Municipal Bonds: Issued by states and local governments; typically have tax advantages in certain jurisdictions.
Corporate Bonds: Issued by private companies; generally have higher yields to offset the higher credit risk.
Agency or Supranational Debt: Issued by an agency or organization, which provides a guarantee of repayment; credit risk of the security depends on the terms of the security.
Credit quality of an issue is generally defined by a rating classification (e.g. Investment Grade vs. High-Yield). The yields of lower rated issues tend to be higher to account for the increased risk of default, however, there can be large price drops in lower rated issues during periods of heightened concerns about defaults.
2. Maturity/Duration/Interest Rate Sensitivity
The maturity date defines the length of time until the security matures and the principal is returned to the holder. Duration defines the approximate percentage drop in price for every one percent increase in the yield of the security. Generally, the longer the maturity date of the security, the longer its duration, and thus, the more volatile the security will be.
Comparison of the characteristics of the three different maturity categories:
Treasury Bills (Short-Term): Low interest rate sensitivity and relatively low yields.
Notes (Medium-Term): Moderate interest rate sensitivity and moderate yields.
Bonds (Long-Term): High interest rate sensitivity and larger price fluctuations.
When interest rates rise, the attractiveness of older, lower-coupon bonds decreases, causing their prices to fall. When interest rates fall, the prices of the bonds may increase. Thus, two bonds of the same credit quality may have vastly different risks.
3. Design of Coupon and Timing of Cash Flows
The design of the coupon of a fixed-income security will determine both the timing of the receipt of interest income and the reinvestment risk of the security.
Examples of common coupon structures:
Fixed-Rate Coupons: Interest income is received in equal installments; most predictable form of interest income.
Floating-Rate Coupons: Payment amounts are adjusted to a reference rate; less affected by rate increases.
Zero-Coupon Bonds: No periodic interest payments; return is generated from buying the security at a discount to face value and receiving face value at maturity.
Inflation Indexed Bonds: Payments are made in reference to an inflationary index; protects against the decline in purchasing power caused by inflation.
Fixed-Rate Bonds provide predictable interest income, but the value of the bond will decline if interest rates rise. Floating-Rate Securities are likely to retain value better in an environment where interest rates are increasing, but will experience decreased interest income if interest rates decline.
4. Embedded Options, Liquidity and Tax Implications
Some fixed-income securities have embedded options that can modify the cash flow characteristics when the cash flows occur. Some fixed-income securities have limited liquidity, making it difficult to purchase or sell the security quickly at a fair price. Taxes can also have an effect on the actual return on the investment.
Features to consider when evaluating fixed-income securities:
Callable bonds: The issuer has the option to call back the security before maturity (generally when interest rates decline); limits upside potential for the investor.
Putable bonds: The investor has the option to retire the security before maturity; allows investor to reduce exposure in uncertain markets.
Convertible securities: Can be exchanged for common stock of the corporation; adds equity-like characteristics to the investment.
Liquidity: The ability to trade the security in sufficient quantity can result in wider bid/ask spreads and higher transaction costs.
Tax implications: Depending upon the jurisdiction, some bonds have tax implications that differ from other bonds.
Similar to other aspects of investing, the characteristics of the individual security can be as important as the yield. For example, two bonds with identical coupons can produce vastly different results due to embedded options and transaction costs.
Conclusion
While there are many ways to characterize fixed-income securities, they generally can be differentiated based on the risk profile of the issuer, the maturity and duration of the security, the design of the coupon of the security, and any embedded options. Each characteristic of a fixed-income security will influence how the security behaves under changing interest rates, credit events, inflation and changes in market liquidity. Investors must analyze the underlying determinants of a bond’s price and cash flow timing to effectively evaluate and compare bonds.
Understanding the characteristics of a bond that influences price movement and cash flow timing will improve investment decision-making and minimize unexpected outcomes in changing economic environments, and especially when once perceived “safe” income-generating instruments begin to behave in a manner inconsistent with their past behavior.