In our previous blog, we learned about the definition of fixed income securities, their key features, the most common types of fixed income instruments available in India, and the benefits of investing in fixed income securities.
If you want to get a basic understanding of fixed income instruments, you can access the first chapter here.
Difference between Fixed Income Securities and Equity
Fixed income securities and equity (stocks) are two distinct asset classes with different characteristics and risk profiles. Here are the key differences between the two:
Ownership: When you invest in fixed income securities, you are essentially lending money to the issuer in exchange for regular interest (or coupon) payments and the return of the principal amount at maturity. In contrast, when you invest in equity, you become a partial owner or shareholder of the company, with a claim on its assets and earnings.
Income Generation: Fixed income securities provide a fixed or predetermined stream of income in the form of periodic interest payments. The interest payments are usually fixed and specified at the time of issuance. In contrast, equity investments do not guarantee any fixed income. Instead, shareholders participate in the company’s profitability through dividends, which are discretionary and dependent on the company’s performance.
Risk and Return: Fixed income securities are generally considered less risky than equity investments. Bondholders have a higher claim on the issuer’s assets and earnings, making them more senior to equity holders in case of bankruptcy or financial distress. However, fixed income securities typically offer lower potential returns compared to equity investments, which carry higher risk but also the potential for higher capital appreciation.
Volatility: Equity investments are subject to greater price volatility compared to fixed income securities. Stock prices can fluctuate significantly due to market conditions, company-specific news, economic factors, and investor sentiment. Fixed income securities, on the other hand, are relatively more stable in terms of price movement, as their returns are primarily driven by interest rate fluctuations and credit risk.
Voting Rights and Participation: Equity investors have voting rights in the company, allowing them to participate in corporate decisions and governance matters, such as electing the board of directors or approving major company actions. Fixed income investors do not have voting rights or direct participation in the company’s decision-making process.
Long-Term Growth Potential: Equity investments have the potential for long-term capital appreciation as the company’s value and earnings grow over time. Fixed income securities, while offering more stable income, may not provide the same growth potential.
Liquidity: Stocks of large, well-established companies with high trading volumes tend to be highly liquid. However, smaller or less actively traded stocks may have lower liquidity, making it more challenging to buy or sell them quickly. On the other hand, fixed income securities, like bonds, are moderately liquid. While selling bonds in the secondary market may be more challenging if buyers are scarce, there is the assurance of receiving the principal amount back upon bond maturity. In contrast, if the price of a stock decreases, there is a risk of losing the invested money.
Before investing in fixed-income securities, it’s important to consider several factors to make informed investment decisions.
What are the risks related to fixed income securities?
Interest Rate Risk: Fixed income securities are sensitive to changes in interest rates. When interest rates rise, the market value of existing fixed income securities tends to decline, as newer securities offer higher yields.
Credit Risk: Credit risk refers to the risk of default by the issuer. If the issuer is unable to make interest payments or repay the principal amount at maturity, investors may face a loss. Credit ratings provided by rating agencies can help assess the creditworthiness of issuers.
Inflation Risk: Inflation erodes the purchasing power of future interest and principal payments. Fixed income securities with fixed interest rates may not provide adequate protection against inflation. If the inflation rate exceeds the fixed interest rate, the real return on the investment may be negative.
Liquidity Risk: Liquidity risk arises when investors are unable to sell their fixed income securities at a desired price or timeframe. Less liquid securities may have limited buyers, leading to potential challenges in selling the investment when needed.
Call Risk: Callable bonds carry the risk of being redeemed by the issuer before the scheduled maturity date. If interest rates decline, the issuer may exercise the call option to refinance the debt at a lower cost, leading to potential early redemption and the loss of future interest payments.
Reinvestment Risk: Reinvestment risk occurs when interest or principal payments from fixed income securities are reinvested at lower interest rates. This can impact the overall yield or income generated by the investment if the new investments have lower yields than the original securities.
Currency Risk (for foreign bonds): Investing in fixed income securities denominated in foreign currencies exposes investors to currency risk. Fluctuations in exchange rates can impact the value of interest and principal payments when converted back into the investor’s home currency.
Prepayment Risk: Prepayment risk applies to mortgage-backed securities (MBS) and certain other debt instruments where borrowers have the option to prepay their loans. When interest rates decline, borrowers may refinance their loans, resulting in early repayment of the underlying securities and potential reinvestment challenges for investors.
Regulatory and Legislative Risk: Changes in regulations or legislation can impact fixed income securities. For example, changes in tax laws or regulatory frameworks may affect the tax treatment or issuance of certain securities, affecting their value or income potential.
Event Risk: Event risk refers to unexpected events that can impact the issuer’s ability to make payments. These events may include natural disasters, regulatory changes, or financial crises that adversely affect the issuer’s financial stability and creditworthiness.
Spread Risk: Spread risk refers to changes in the yield spread between fixed income securities and benchmark rates. When spreads widen, the relative value of the securities may decrease, impacting their market prices.
Concentration Risk: Concentration risk arises when a fixed income portfolio is heavily weighted towards specific issuers, sectors, or regions. This lack of diversification can expose the portfolio to higher risks associated with those specific areas.
Market and Volatility Risk: Market and volatility risk refers to the potential for price fluctuations in fixed income securities due to overall market conditions, investor sentiment, and macroeconomic factors. Market disruptions or increased volatility can impact the value of fixed income investments.
Things to consider before investing
Investment Objectives: Figure out your investment objectives and goals. Determine whether you seek regular income, capital preservation, or a balance between income and growth. This will help you choose the appropriate fixed-income instruments that align with your objectives. For eg, You can consider Corporate Bonds, High-Yield Bonds, or Fixed Deposits (FDs) if you are looking for regular income. For capital preservation, you could try low-risk instruments such as Government bonds (Treasury Bills, or sovereign bonds etc).
Risk Tolerance: Fixed income securities carry various risks, including interest rate risk, credit risk, inflation risk, and liquidity risk. Understand your comfort level with these risks and select securities accordingly.
Yield and Return Potential: Evaluate the yield and return potential of the fixed income securities you are considering. Understand the interest rate environment, prevailing yields, and expected returns. Compare the potential returns with the level of risk involved.
Credit Quality: Examine the credit quality of the issuer. This is particularly important for corporate bonds and other debt instruments. Consider the credit rating of the issuer assigned by rating agencies to assess the likelihood of default and the associated credit risk.
Maturity and Duration: Evaluate the maturity and duration of the fixed income securities. Short-term securities have lower interest rate risk compared to long-term securities. Consider your investment horizon and liquidity needs to choose an appropriate maturity.
Diversification: Emphasize diversification within your fixed income portfolio. Spread your investments across different issuers, sectors, and types of fixed income securities to reduce concentration risk. Diversification can help mitigate the impact of any individual security’s performance.
Market Conditions: Stay informed about market conditions and economic factors that can impact fixed income securities. Monitor interest rate trends, inflation expectations, and overall market conditions. Changes in these factors can influence the performance of fixed income investments.
Tax Implications: Understand the tax implications of investing in fixed income securities. Different types of fixed income securities may have varying tax treatment. Consider the tax benefits, exemptions, and any applicable tax rates to evaluate the after-tax returns.
Professional Advice: Seek guidance from financial advisors or professionals with expertise in fixed income investments. They can provide valuable insights, help assess risk-reward profiles, and assist in constructing a well-diversified portfolio.
In Chapter 3, we dive deep into the process of investing in fixed-income securities and how fixed income securities are regulated in India. Read here.
