The stock market is a constant battle between the bulls who believe valuations will rise and the bears who believe valuations will fall. As a result, the stock market is known for tremendous fluctuations in value, with gains when bulls take the lead and declines when bears take hold.
With the bears and bulls constantly at odds, investors look for ways to shield their investment portfolios from the significant declines that result from this volatility. One of the best ways to do so is to practice diversification using fixed-income securities.
By maintaining a mix of stocks and fixed-income securities, investors have the ability to enjoy upsized gains when market conditions are positive and benefit from hedged bets when markets turn negative.
What Are Fixed-Income Securities?
Fixed-income securities are debt securities issued by a government or corporation in return for funding to finance its operations. In simple language, it is an IOU with documented, defined features that detail the amount borrowed, the amount and timing of interest payments to be made by the borrower to the lender, and the remedies available to the lender if the borrower defaults.
Although debt securities do not transfer ownership interests (equity) in a company, they establish a priority of the lender’s claim for repayment in the event of the borrower’s default or bankruptcy. The term “fixed-income security” can apply to a variety of different debt instruments including:
- Bonds. A bond usually refers to the formal issue of debt by the borrower to a set of lenders — the buyers of the bonds. The terms of the loan — maturity date, interest rate, timing of interest payments, and physical collateral securing payment — are detailed in a legal contract called an indenture accompanying the bond issue.
- Debentures. A debenture is a bond that is unsecured. In other words, there is no physical collateral to ensure the borrower complies with the terms of the indenture. The purchaser of a debenture must rely solely on the promise of the borrower to repay the debt. The most common form of debentures are U.S. Treasury bonds.
- Promissory Notes. A promissory note is another type of contract between borrower and lender; the term usually applies to private loans between the specific parties, often on a one-off basis. Promissory notes tend to be short-term and unsecured.
- Certificates of Deposits (CD). The repayment of principal and interest for CDs issued by banks and savings and loan institutions is guaranteed by the Federal Deposit Insurance Corporation (FDIC) for amounts up to $250,000. The National Credit Union Administration guarantees the CDs of credit unions. Certificates of deposit are typically available in $1000 units with a fixed term and interest rate, usually higher than the interest rate paid on savings accounts.
- Asset-Backed Securities (ABS). These fixed-income securities are collections of other debt obligations that have been “securitized.” Investors can purchase pieces of packaged credit card receivables, auto loans, student debt, or home mortgages. The principal repayment period and interest rate vary as the individual loans within a package are repaid.
- Annuities. Annuities are a specialized kind of debt instrument issued by insurance companies wherein certain payments are required starting immediately or in the future. Many advisers discourage their use in an investment portfolio. Annuities are not securities, but are regulated by the insurance laws of the state where issued. The rate of return paid by the insurance company may be fixed or variable, and the length of payment may be for a specified period or for your entire lifetime — or in some cases, the lifetime of both you and your spouse.
- Exchange-Traded Notes (ETNs). Neither principal nor interest is guaranteed when investing in exchange-traded notes. The return depends on the performance of an identified index or asset class such as the price of oil or the S&P 500. The ETN owns no assets and pays no interest; the return to the investor is simply the difference between the price of the underlying index at purchase and at maturity. The Financial Industry Regulatory Authority (FINRA) details exchange-traded notes and their investment advantages and risks, warning that investors can take significant losses in these notes.
- Bond Funds. Many investors prefer to invest in mutual funds rather than purchasing individual securities. A bond fund is a mutual fund that invests solely in debt instruments. Investors receive a proportionate share of the interest paid each month while principal payments are reinvested into new bonds by the manager. Like ETNs, there is no guaranteed return of principal; the price of the mutual fund shares vary according to the underlying values of the fund’s investments. Investors buy and sell the fund shares like any other security.
- Bond ETFs. Although similar to a bond mutual fund, bond ETFs are not actively managed, but designed to reflect the movement of a designated bond index such as the Bloomberg Barclays U.S. Aggregate Bond Index. Shares of ETFs trade like stocks, so there is no guarantee that an investor will recover their initial investment. Unlike an exchange-traded note or individual bonds, traditional bond ETFs never mature because the maturity dates of the underlying bonds continuously vary. Some managers have offered bond ETFs with targeted maturity dates. Although these are relatively new investment vehicles, they have taken off with the fixed-income investing community, and several targeted-maturity bond ETFs have flooded the market.
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Legal Features of a Fixed-Income Security
Fixed-income securities share distinct features from equity securities that are detailed in the indenture and include:
- Par Value. Sometimes referred to as face value, par value is the amount of money that will be paid to the owner of the security when the loan is due. It is also the amount of principal on which interest is calculated. Par value of bonds is usually $1,000. Bonds that sell for less than par value are “discount ” bonds, while those that sell above par value are “premium” bonds.
- Interest Rate. Also called the coupon rate, the interest rate is the percentage amount specified in the indenture that is multiplied by the par value to calculate the dollar amount of the interest payment for each period. For example, if the indenture calls for a 6% rate on a $1,000 par value bond, the registered owner of the bond will receive $60 of interest per year. The security might have a fixed interest rate for the life of the bond or a “floating” interest rate that changes periodically according to a predetermined formula. As is the case with any loan, interest rates are highly correlated with the credit quality of the borrower.
- Payment Frequency of Interest. The rate of interest payments — annual, semiannual, or monthly — is documented in the indenture. The frequency of payment does not influence the interest rate. For example, a bond with a 6% rate could make a single annual payment of $60, two semiannual payments of $30, four quarterly payments of $15, or 12 monthly payments of $5.
- Maturity Date. Also known as the principal repayment date, the maturity date is the future date on which the issuer of the security must redeem the debt. The difference between the issue date and the maturity date is the “life” of the bond, which gradually decreases over time.
- Collateral. Issuers of debt might provide collateral securing their repayment of principal and interest. This is a process most Americans are familiar with from common purchases of high-value assets like vehicles and homes. If the borrower fails to pay back the debt as promised, the collateral assets are surrendered to pay back the lender. Collateral can range from physical assets to a “sinking fund,” to which the issuer contributes money throughout the life of the bond, building a reserve to ensure redemption occurs as promised.
- Remedies for Default. In the event of default — failure to pay interest and principal as agreed — the owner of the bond may require the principal amount and any unpaid interest to be repaid immediately and pursue other measures, including the capture of collateral assets, conversion into equity owners, and other remedies defined in the indenture to secure payment.
Issuers of Fixed-Income Securities
Fixed-income securities can be issued by the federal government, state governments, municipalities, and political entities such as water districts, toll systems, and public airports. Corporations and other legal entities such as partnerships, associations, and individuals can issue fixed-income securities as well.
The term municipal bond refers to debt securities issued by state, city, and local governments. As such, they are often referred to as government bonds. The interest paid on a municipal bond is free from federal income tax as well as state or local income tax in the state where the bond was issued. Because the interest received on a municipal bond is excluded from taxable income, municipal bonds generally have lower interest rates than corporate bonds of similar quality. Buyers should be aware that interest on some municipal bonds may be subject to alternative minimum tax.
Taxpayers in the higher income brackets should calculate the after-tax return of a corporate bond versus the probable return of a municipal bond to determine the highest net return on their potential investment.
Public and Private Issues of Debt Securities
Debt securities may be publicly or privately issued. Public issues are registered with the Securities Exchange Commission (SEC) and comply with federal and state laws. Debt instruments registered with the SEC can be bought and sold freely.
Private issuers of debt securities must also meet federal requirements for an exemption from security law when it comes to specific transactions like a private placement, a popular method for entrepreneurs raising startup capital.
Buyers of private securities — bonds or equity — should be aware that the SEC restricts the subsequent sale of securities purchased through a private placement, which could result in liquidity concerns should you need to sell your investment to recoup cash.
Registered Bonds Versus Registered Owners
While the term “registered” applies to publicly traded bonds, it can also refer to registered owners of the bonds whose names and identifying information are on file with the company (or its agent) issuing the bonds. This information is maintained in a secure electronic file and is updated every time ownership in the bond changes hands.
Historically, paper bond certificates included a series of coupons that were clipped and submitted for payments. Owner identification did not appear on the physical document or the attached coupons, so the entity who redeemed the bond or coupon received payment from the issuer. In other words, people or entities could sell or redeem a bond anonymously as long as they possessed the physical document.
Because there was no way for the issuer to verify if a certificate had been lost or stolen, new issues of these “bearer bonds” were outlawed in the U.S. by the Tax Equity and Responsibility Act of 1982. Ironically, U.S. companies and the U.S. Treasury have continued to issue bearer bonds in Europe and to non-U.S. residents.
Hybrid Securities and Sweeteners
The traditional structure of most fixed-income securities is to pay consistent interest for a fixed term, ending with the redemption of the debt at face value. Over time, borrowers have added features — “sweeteners” — to attract investors or increase the issuer’s options. These features include:
- Callable or Redeemable Clauses. With callable or redeemable securities, the issuer has the option to force bondholders to redeem their bonds after a specific date for a predetermined price. This option benefits the issuer because bonds with higher coupon rates than the current market interest rate are most likely to be called; the borrower will only leave callable bonds outstanding if they are paying at or below current market rates. If called, the investor loses any price increase above the call price of the bond.
- Retractable Clauses. The reverse of the call feature, retractable securities give investors the option to redeem their bonds at par at a predetermined date if they wish. For example, if interest rates rise above the coupon rate, the investor’s bonds will drop in value. Rather than selling the issued bonds at a loss, the investor can force the issuer to redeem the bonds at face value.
- Extendible Clause. With extendable securities, investors have the option to extend the maturity date of the bond for a definite period. This feature is particularly useful if market interest rates have fallen below the matured bonds’ coupon rate, allowing them to collect interest for a period at a higher than market rate.
- Variable-Rate Features. The coupon rate for variable-rate securities is tied to a specific market interest rate — Prime or Libor — and is periodically adjusted to that rate. Typically, there is a minimum and maximum rate that can limit the increase and decrease of the coupon rate. If prevailing interest rates rise, the investor benefits; if rates fall, the issuer benefits.
- Protective Requirements. These features are intended to benefit investors by specific assurances. The requirements might include a pledge of specific collateral, a promise not to sell any assets above a specified dollar amount without bondholder approval, or the implementation of a sinking fund — a fund built by setting aside a percentage of revenue until the cost of maturity is covered.
- Convertible Option. With convertible securities, bondholders have the option to convert their bonds into a fixed number of common shares of the issuing company for a fixed period. This option allows bondholders to participate in the future growth of the issuing company. For example, if a bond has a conversion ratio of 20 common shares for $1,000 face value, the conversion rate would be the equivalent of $50 per share. The convertible bond will trade as a fixed-income investment whenever the common stock of the issuer trades at or below $50. If the common stock of the same company trades at $60 per share, the bond would trade at or near the equivalent of the converted shares’ value, or $1,200 — 20 shares at $60 per share — affected only indirectly by market interest rates.
- Exchange Option. Similar to convertible bonds, an exchange feature allows bondholders to exchange their bonds for common stock of a related company of the issuer. For example, a bond issued by a parent company may be changeable into common stock of a subsidiary, or vice versa.
Some issuers might attach “warrants” — the right to purchase a specific number of common shares of the issuer for an identified price and a limited period — to a bond. Warrants are a separate asset from the bonds and can be severed from the bond to trade as independent securities.
Issuers may combine features to achieve specific purposes. For example, a company might combine call and convertible elements. As a consequence, they would force conversion by calling the bond when the common stock trades above the conversion price. A bondholder is likely to convert the bond and sell the shares rather than receive face value on the call, resulting in an immediate return of original principal value, plus market value growth.
Interest Rates and Bond Prices
The cost of borrowing money — the interest rate — continually changes due to:
- Credit Supply and Demand. When there are more borrowers than lenders, interest rates rise until the parties are in balance. When there are more lenders than borrowers, interest rates fall until an equilibrium is reached.
- Inflation. Interest rates rise when inflation increases because the funds used to repay the loans will have lower purchasing power than the funds initially loaned. Investors generally distinguish between the nominal return and the real rate of return, the latter of which considers the effects of inflation on real purchasing power.
- Government Actions. The Federal Reserve uses its monetary policy to stimulate or slow down economic growth. The Fed, as it’s commonly known, sets the federal funds rate — the interest rate that financial institutions charge each other for short-term loans — which affects commercial rates. The Fed also makes open-market transactions that affect the availability of credit, such as buying up corporate bonds.
Bond prices and market interest rates generally move in opposite directions. When interest rates rise, bond prices fall and vice versa. This inverse relationship is the interest rate risk that all fixed-income investors bear.
For example, if you sell a bond before it matures, the market price may be higher or lower than your original cost due to changes in the market interest rate. The coupon rate on an issued bond is fixed while the market interest rate continuously changes. As a consequence, the market price of your bond fluctuates to provide buyers similar rates of return on bonds with different coupon rates and maturities that they could buy elsewhere.
Holding a bond until maturity reduces the risk because the face value will be repaid to you in full regardless of changes in interest rates.
Credit Ratings of Fixed-Income Securities
Like all borrowers, corporations and government entities who borrow money pay interest based on lenders’ perception of their creditworthiness. Individuals with poor credit ratings generally pay more for loans than those with higher credit ratings. Similarly, bond issuers who are considered less creditworthy pay a higher interest rate when borrowing funds.
Three independent credit rating agencies — Standard & Poor’s, Moody’s, and Fitch — account for the majority of the credit ratings for issuers of corporate debt as well as state and municipal debt. Each issue is analyzed and ranked based on the agency’s opinion of the borrower’s ability to pay interest and repay principal as scheduled, much like personal credit scores are calculated by FICO. Each of the agencies has a grading system that ranks credit from “investment grade” to “speculative,” with investment grade representing good credit and speculative representing bad credit.
Securities issued by the United States Treasury have generally been considered the highest quality of debt securities in the world, with all three rating agencies historically assigning their top ranking to the country’s debt. In 2011, S&P downgraded U.S. debt from “AAA” to “AA+” for the first time in history. Their rating has continued in place since, even as the two other dominant credit agencies continue to give the country their highest scores.
Fixed-income investors use several metrics for determining the value of the securities they purchase.
Duration is a measure of sensitivity to changing interest rates; the longer the duration, the more the price of a bond will fall when rates rise. Duration measures the time it takes to recover half of the present value of all future cash flows from the bond, discounted by its yield. Bond investors should recognize that the greater the duration of a bond, the higher its price volatility will be with interest rate changes.
There are many ways to calculate duration; one of the most popular duration calculators was developed by Frederick Macaulay and can be found for free online. Duration is affected by:
- Bond Price. Bonds purchased at a premium (above par) have lower duration than bonds purchased at a discount (below par).
- Coupon Rate. Lower coupon rates have longer durations because a higher coupon rate provides more income early.
- Maturity. Duration is positively related to the term of the bond — the longer the term, the higher the duration.
- Yield to Maturity (YTM). Bonds with higher YTMs have shorter durations.
- Presence of a Sinking Fund. A sinking fund lowers a bond’s duration because it adds to the early cash flows.
- Call Provisions. Bonds with a call provision have shorter durations because the bonds are likely to be redeemed before maturity.
Understanding duration can help investors choose bonds that best fits their needs. For example, an investor who believes that interest rates are likely to rise in the future should consider bonds with high coupons and shorter maturities.
Current Yield (CY)
The current yield, or annual return on the dollar amount paid for a bond, regardless of its maturity, is calculated by dividing the yearly dollars received in interest by the price paid for the bond. If you buy a bond at par, the current yield equals its coupon rate. Thus, the current yield on a par-value bond paying a 5% rate is 5% ($50/$1,000).
If the market price of the bond is more or less than par, the current yield will be different. For example, you would pay $833.33 for the same 5% bond if interest rates were to rise to 6% based on the calculation ($50/$833.33). Bond prices would rise to $1,250 if interest rates fell to 4% based on the same calculation ($50/$1,250).
Yield to Maturity (YTM)
Current yield considers only the bond’s annual return while yield to maturity, or YTM, provides the total annual return you receive by holding it until maturity. YTM enables you to compare bonds with different maturities and coupon rates. It includes all interest to be paid over the life of the bond, plus any capital gain you will realize at maturity if you purchase the bond below par — or minus any capital loss you will suffer if you bought the bond above par.
The YTM calculation is complex and requires multiple iterations to arrive at an exact number. The good news is that there are many online calculators — Finance Formulas, Investing Answers, DQYDJ — available. Moreover, you can also ask your financial advisor to provide you with the exact yield to maturity for any bonds you are considering buying.
Yield to Call (YTC)
Yield to Call, or YTC, is applicable to bonds that have a call feature. It is similar to the YTM except for the assumption that the bonds will be called at the first opportunity. The YTC of a bond is typically lower than its YTM because the call feature limits any appreciation above the call price. If multiple call dates are present, potential investors should calculate YTC for all dates, compare them to YTM, and select the lowest return — sometimes called yield to worst.
Fixed-Income Securities Pros and Cons
Fixed-income products offer a long list of benefits to investors who purchase them. However, they also have limitations and are not without risk. When it comes to fixed-income securities, the most important pros and cons to consider include:
Pros of Fixed-Income Securities
Investments in fixed-income securities offer the investor several perks. Some of the most important to consider include:
- Income. The key to fixed-income securities is the fact that they provide fixed income. As a result, those who invest in them will receive regular payments from the issuer of the security, making them popular choices among retirees and an important part of any investor’s diversified portfolio.
- Liquidation Priority. In the event of the bankruptcy of the issuer of a fixed-income security, the issuer’s assets will be used to repay fixed-income investors before paying investors who hold shares of common stock.
- Stability. Because fixed-income securities provide fixed income and are a higher priority in an event of liquidation than shares of stock, they don’t experience the same price volatility that’s seen with traditional stock. This stability is attractive for the risk-averse investor as well as an effective hedge for those with a higher-risk investment portfolio.
Cons of Fixed-income Securities
No investment product is perfect. Although fixed-income securities are attractive choices, there are also some bumps in the road that you’re likely to encounter when putting your money into these investment vehicles.
- Slow Growth. In the investing world, low risk generally equates to low potential reward. Because fixed-income securities are relatively low-risk investments, the potential return on investment is lower than you can expect to see from the purchase of higher-risk investment vehicles such as common stock.
- Risk Still Exists. Investors often look to fixed-income securities as a risk-free investment. There’s no such thing as a risk-free investment. Even the highest credit quality fixed-income investments come with a risk of default. So, it’s never a good idea to blindly make investment decisions in the stock market, bond market, or elsewhere.
- Inflation Risk. When economic conditions are positive, prices tend to rise in a process known as inflation. When prices rise but coupon payments don’t, your investment portfolio isn’t taking part in positive market movements during economic uptrends, ultimately leading to an opportunity cost.
Fixed-income securities are an important part of any well-diversified portfolio. However, as with any investment vehicle, not all fixed-income securities are created equal. When shopping for fixed-income products, it’s important to consider your goals and look for an investment that will fit in well with your investment strategy.
It’s also important to remember that fixed-income securities are a low-risk investment, but are far from risk-free. The creditworthiness of the company or municipality that issues the security will not only determine the level of income you’re paid, but also the risk of default that you assume when you purchase the security. As such, it’s important to do your research and make sure that the investment you make is in line with your appetite for risk.
Nonetheless, due to the safety and stability offered by most fixed-income products, they are an integral part of just about every investment portfolio, even if for nothing more than diversification purposes.