Fixed income securities are investment instruments that provide a fixed stream of income to the holder over a specified period of time. These securities represent debt obligations issued by governments, municipalities, corporations, or other entities to raise capital. Investors who purchase fixed income securities essentially lend money to the issuer in exchange for regular interest payments and the return of the principal amount at maturity.
Key features of fixed income securities
Fixed income securities possess several key features that differentiate them from other types of investments. Understanding these features is crucial for investors seeking to include fixed income securities in their portfolios.
Fixed Interest Payments: Fixed income securities offer predetermined interest payments at regular intervals, typically semi-annually or annually. The interest rate, also known as the coupon rate, is specified at the time of issuance and remains constant throughout the life of the security.
Maturity Date: Fixed income securities have a specified maturity date, which is the date when the issuer repays the principal amount to the investor. Maturities can range from a few months to several decades, depending on the type of security.
Principal Repayment: At maturity, the issuer repays the original principal amount invested to the bondholder or investor. This distinguishes them from equity securities, where the return depends on the performance of the underlying company or asset.
Credit Quality and Default Risk: Fixed income securities carry varying levels of credit risk which refers to the possibility that the issuer may default on interest or principal payments. Government bonds, particularly those issued by stable countries, are considered to have lower default risk compared to corporate bonds or municipal bonds. Credit rating agencies assign ratings to fixed income securities to indicate their creditworthiness.
Market Price and Yield: Fixed income securities can be bought and sold in the secondary market before their maturity date. The market price of these securities fluctuates based on changes in interest rates, credit ratings, and market conditions. The yield of a fixed income security represents the effective interest rate an investor receives based on the security’s market price and coupon payments.
Types of fixed income securities
In India, the most common types of fixed income securities include:
Government Bonds: Government bonds, also known as G-Secs or government securities, are issued by the Indian government to finance its fiscal deficit. These bonds are considered the safest fixed income securities in India as they carry no default risk. Government bonds have different maturities ranging from short-term to long-term bonds. There are different types of G-Sec bonds, such as Treasury Bills (T-Bills), Dated Government Securities, State Development Loans (SDLs), Floating Rate Bonds (FRBs), Capital Indexed Bonds (CIBs) and Sovereign Gold Bonds (SGBs).
Corporate Bonds: Corporate bonds are debt securities issued by companies to raise capital for various purposes such as expansion, working capital, or debt refinancing. These bonds offer fixed interest payments and have specified maturity dates. Corporate bonds in India are available in various credit ratings, reflecting the creditworthiness of the issuing company. Corporate bonds can be categorized based on various factors, including the issuer, credit rating, and features. Some common types of corporate bonds are Investment-Grade Bonds, High-Yield Bonds (Junk Bonds), Non-Convertible & Convertible Bonds, Callable Bonds, Puttable Bonds, Floating Rate Bonds and Perpetual Bonds.
Debentures: Debentures are long-term debt instruments issued by companies to raise funds. They offer fixed interest payments and have specified maturity dates. Debentures can be publicly issued or privately placed, and they may have different features and levels of risk depending on the issuing company. Debentures can be secured (backed by assets) or unsecured (based on the issuer’s creditworthiness).
Debt Mutual Funds: Debt MFs pool money from multiple investors and invest primarily in a diversified portfolio of fixed-income securities such as government bonds, corporate bonds, money market instruments, and other debt instruments. By investing in debt MFs, investors indirectly hold a portion of the underlying fixed-income securities within the fund.
Fixed Deposit Receipts (FDRs): Fixed deposits are investment products banks offer where individuals deposit a specific amount for a predetermined period. The interest rate is fixed for the duration of the deposit, and the principal amount is returned at maturity. They are considered low-risk fixed income investments, and the interest rates may vary depending on the bank and tenure.
Certificates of Deposit (CDs): CDs are negotiable money market instruments issued by banks and financial institutions. They represent time deposits and have fixed maturities, typically ranging from a few days to a year. CDs offer a fixed interest rate and are tradable in the secondary market.
Public Provident Fund (PPF): PPF is a long-term savings scheme offered by the Government of India. It is a fixed income investment option where individuals can contribute a certain amount annually and earn a fixed interest rate. PPF has a maturity period of 15 years, and the interest earned is tax-free.
National Savings Certificates (NSCs): NSCs are fixed income investments offered by the Indian Post Office. They have a fixed interest rate and a maturity period of five or ten years. NSCs can be purchased at designated post offices and provide tax benefits under Section 80C of the Income Tax Act.
Commercial Papers (CPs): CPs are short-term promissory notes issued by corporations to meet their immediate funding requirements. They typically have maturities ranging from a few days to a year. CPs are usually issued at a discount to face value and provide investors with a return upon maturity.
Benefits of investing in fixed income securities
Regular Income: Fixed income securities provide a predictable and regular income stream in the form of interest payments. This can be particularly beneficial for investors seeking stable income or those who rely on investment income for their living expenses.
Capital Preservation: Fixed income securities, especially those with high credit quality, are generally considered less volatile and carry lower risk than equities. They offer capital preservation by providing a return of principal at maturity or upon redemption.
Diversification & Risk Management: Fixed income securities can act as a risk management tool. They offer a more predictable income stream and serve as a cushion during market downturns. Their lower volatility and potential for regular income can help mitigate the impact of equity market fluctuations. Moreover, including fixed income securities in an investment portfolio helps diversify risk. These securities often have a different risk-return profile than equities, and their performance may not be highly correlated with stock market movements. Diversification can reduce the overall volatility of the portfolio.
Liquidity: Depending on the specific security, fixed income investments can offer liquidity. Some securities, such as government bonds and highly traded corporate bonds, have active secondary markets, allowing investors to buy or sell them relatively easily.
Preset Terms and Conditions: Fixed income securities have predefined terms and conditions, including the coupon rate, maturity date, and repayment schedule. This clarity provides transparency and helps investors in understanding the cash flows and expected returns from their investments.
Various Investment Options: Fixed income securities offer a wide range of investment options, including government bonds, corporate bonds, debentures, and certificates of deposit. This allows investors to choose securities that align with their risk tolerance, investment goals, and time horizons.
Tailored Investment Strategies: Fixed income securities provide flexibility in constructing investment strategies. Investors can create portfolios with different maturities, credit ratings, and yields to suit their specific investment preferences and requirements.
Tax Benefits: Some fixed income securities, such as certain government bonds, may offer tax benefits. These benefits can include tax-exempt interest income or deductions for investments made in specific instruments, helping investors reduce their tax liability.
Read Chapter 2 where we dive deep into a comparison between Fixed Income & Equity Investments, some of the risks associated with Fixed Income Securities, and the essential things to consider before investing in fixed income instruments.