Fixed Income

Fixed income refers to securities that offer a steady return to the investors throughout the maturity period. The issuer is obligated to make fixed payments on fixed dates—hence the term ‘fixed’ income is used.

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.

• 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.

Investors can receive a fixed income from debt financing. 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 bonds; timely interest payments 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 rate.

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 appetites, investors can choose between different bonds.

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 LIBOR. On the other hand, Zero-Coupon Bonds, 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-Bills 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 funds replicate the underlying bond market index. These shares can be exchanged on stock exchanges.

Fixed Income Mutual Funds: They are debt funds that ensure regular interest payments and capital appreciation returns.

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.

The price of a bond is the present value of the future coupon payments and the present value of the principal (face value). The following formula is used for calculation:

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

Here,

• C_n is the coupon payment in the maturity period;
• n is the maturity period;
• YTM is the yield to maturity;
• P is the principal value; and
• i 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:

1. Par Bond: The bond is sold at face value when the coupon rate and yield to maturity are the same.
2. Discount Bond: When the coupon rate is less than the bond's yield to maturity, discount bonds are sold below their face value.
3. Premium Bond: Here, the bond's coupon rate is higher than its yield to maturity. Thus, premium bonds are sold at premium prices (higher than the face value of the bond).

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 = $1000
• Annual Coupon Rate = 7%
• Maturity Period = 3 years
• Yield to Maturity = 7% p.a.

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

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

Bond Price = + + +

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.

Solution:

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

Bond Price = + +
+

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.

Solution:

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

Bond Price = + + +

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.

These securities are prone to the following uncertainties:

• Call Risk: With callable bonds, 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.

This has been a guide to Fixed income & its definition. Here we explain fixed income instruments/securities along with market examples. You can learn more about it from the articles below -

• Equity vs. Fixed Income - Compare
• Call Risk
• Fixed Income Careers
• Best Fixed Income Books