Introduction to Fixed Income
Unlike variable-income securities where interest rates may changes throughout investment, fixed income securities are designed to generate a steady and fixed periodic payment. Another characteristic of this type of investment is that the principle is returned at maturity. The most common fixed income products are bonds and Certificates of Deposit(CD).
Bonds are debt or IOUs issued by governments or corporations as a way to raise capital. Like other fixed income products, bonds offer payments at a predetermined date and interest rate, often referred to as a "coupon". Investors therefore know exactly how much interest they will receive from an issuer if they hold the bond until maturity.
For example, a bond with a face value of $2,000, a coupon of 10%, and a maturity of 10 years pays a total of $200 ($2,000*10%) in interest per year for 10 years until maturity. In fact, since most bonds make their interest payments semi-annually, investors would receive two payments a year of $100 each for 10 years. The original $2000 is redeemed after 10 years at maturity.
Types of Bonds
Based on the issuers, bonds generally fall into the following categories: U.S. Treasuries, Municipal Bonds, Agency Bonds, and Corporate Bonds:
- U.S. Treasuries
U.S. Treasuries are issued by the federal government. According to their maturity, treasuries can be divided into bills, notes, and bonds. Bills are short term bonds maturing in less than one year, while notes and bonds have longer maturities. Interest payments earned from treasury bonds are subject to federal income taxes but are exempt from state or local taxes. In general, bills are sold for less than their face value, the discount representing the interest. Notes and bonds are sold at face value, paying interest semi-annually. Since they have very low risk and favorable tax treatment, U.S. Treasury bonds usually offer a lower pretax yield than that of corporate bonds with similar maturities.
- Municipal Bonds
These are bonds issued by towns, cities, local governments, and regional agencies to fund various projects. Their default risk is low but not zero. To many high tax brackets investors, municipal bond investing is a great investment on an after-tax basis because interest payments are usually exempt from both federal income taxes and state taxes if investors reside in the issuing state.
- Agency Bonds
Agency bonds are issued by various government agencies. These bonds are considered to have low risk, but are not fully guaranteed in the same way as U.S. Treasuries. They generally offer higher interest rates than government bonds because the returns are taxable.
- Corporate Bonds
Corporations issue corporate bonds as a way of raising capital in order to finance large investment projects. While paying higher interest than other types of bonds, interest from corporate bonds is taxable and the bonds have a higher default risk. Maturity of corporate bonds varies from one years to more than 30 years. Firms sometimes issue bonds that are convertible or callable. Convertible bonds allow bond holders to convert their bonds into stocks, while callable bonds allow the corporations to redeem an issue prior to maturity.
- Zero Coupon Bonds
Also known as accrual bonds, zero-coupon bonds pay no interest until maturity. These bonds are sold at a deep discount from face value and are redeemed at full face value at maturity. The most popular zero coupon bonds are those backed by Treasury obligations. Under U.S. tax law, the imputed interest on a zero-coupon bond is taxable as it accrues, even though there is no cash flow.
Investing in Bonds
Investors can purchase bonds through a brokerage firm. At Firstrade, investors can purchase all the aforementioned types of bonds through the online trading platform.
Are Bonds Safe?
Bonds are generally considered a safer way to invest because they offer fixed interest payments and a promise to return the principal at maturity. However, like all other investments, investing in bonds are not without risk. For example, municipal bond investing is a low risk investment because it is very unlikely that a municipality would go bankrupt, but if it does, the municipal bonds issued by that city would default. However, there are also companies issuing junk bonds that provide investors with very high interest rates in order to compensate for the great uncertainty about the issuing firm's ability to meet its debt obligations. Therefore, not all bonds are low risk investments.
Picking the Right Bonds & Credit Ratings
The major risk of investing in bonds comes from the concern about the issuers' ability to meet its scheduled interest and principal payments. Generally, a bond's default risk is related to the "coupon" or interest rate. U.S. government securities such as U.S. Savings Bonds are considered risk free since the chance of default is virtually zero. On the other hand, corporate bonds are considered to have more risk so they offer higher returns than U.S. Savings Bonds.
Several credit rating companies, such as Standard & Poor's, Moody's, and Fitch, help investors evaluate the default risk of bonds by assigning them ratings. For example, according to Standard & Poor's, A to AAA rating bonds are issued by corporations that have adequate to strong capacity to make interest payment on time. As the ranking goes down bonds pay higher interest rates but also encounter higher default risk. Bonds rated a B or C level are considered to be speculative.
A Few Terms to Know
The following are some common terms to know when investing in bonds:
- Yield to Maturity (YTM)
Indicates the total return an investor will receive if the investor holds the bond to maturity, assuming the interest payment is reinvested at the same rate as the current yield on the bond. Bond investors usually refer to YTM as yield.
- Face Value
Also known as "par value" or "par", face value is the amount paid to bond holders at maturity. Depending on the credibility of the issuers and the interest rate, bonds can be sold either above or below face value.
Also called "coupon rate" or "coupon percent rate", is the interest rate stated on a bond, note, or other fixed income security when it is issued. In general, the coupon is paid semiannually and expressed as a percentage of the face value.
- Accrued Interest
This is the interest that has accumulated on a bond or other fixed income security since the last interest payment was made up to, but not including, the settlement date.
Certificates of Deposit
Generally issued by commercial banks, a Certificate of Deposit (CD) is a savings certificate that entitles the bearer to receive payment at fixed interest rate. Like other fixed income products, a CD has a maturity and the principal is returned to the investor at maturity. The interest earned from a CD is taxable.
The Effect of Inflation on Fixed Income Products
Yes, inflation hurts!
Interest generated from fix income securities remains the same throughout the entire life of the investment. A down side of this is that the principal and the interest are vulnerable to inflation. A $200 interest payment received three years from now is not likely to have as much purchasing power as a $200 payment received today. Fixed income products therefore appears to be less attractive to investors when inflation is higher.
To minimize the effect of inflation on fix income securities, the federal government now offers a 10-year note called an inflation-protected security (IPS). Based on changes in the consumer price index, the redemption value of the note is subject to adjustment every six months. Therefore, when a note is redeemed at maturity, an investor gets back an amount which reflects an adjustment for lost purchasing power during the note's life. However, since return on such a bond is protected from inflation, it tends to pay a lower interest payment than other types of bonds.
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