Fixed income securities include government bonds, treasury bills and corporate deposits. These are issued by a government, corporation or any entity to obtain funds to finance its operations. They offer a fixed rate of return in the form of interest at periodic intervals. The principal is repaid on maturity.
These instruments are ideal for people who are risk averse and are looking for stable and regular income. As most instruments are rated by rating agencies, it is easier for a investor to determine the safety level of the fixed income instrument.
In case of Corporate Deposits, tenure can vary from 1 to 10 years and most issuers do offer pre-mature withdrawal option though it may come with a penalty clause. Corporate Deposits offer high rate of return than Bank FDs. Senior citizens are also offered higher rates as compared to general public.
Most issuers will offer interest on monthly, quarterly or annual basis and the depositor can select whichever option suits him.
Investors can also benefit by investing in tax saving bonds.
Default Risk: Debt instruments can be broadly divided into two categories- those issued by the Government and those issued by Corporates. All government debt is guaranteed by the exchequer and hence the risk of default is virtually zero. However company deposits do not come with such assurances. The company’s ability to service its debt depends on its financial health. An ailing company can default on payment of interest and/or principal which can adversely affect the investor. One method of gauging the company’s financial health is to check its credit rating. AAA is the highest and D is the lowest rating. As the rating declines, the chances of default increase. A good company with strong financials will generally enjoy a high credit rating (AA for example). Govt securities will generally have a AAA rating as default risk is zero.
Interest Rate Risk: There is an inverse relationship between bond prices and interest rates. When interest rates decline, the price of bonds trading in the market increases and vice-versa
This is because when interest rates start falling investors start buying the bonds offering a higher rate of interest than the prevailing market rate so that they can lock the higher interest rates for as long as possible. This increase in demand for bonds leads to an increase in the bond price. On the contrary, if interest rates began to rise, investors would try to get rid of bonds paying lower rate of interest forcing the bond prices to fall.
Zero coupon bonds are more sensitive to interest rate changes and the prices of these types of bonds also tend to fluctuate more than higher coupon bonds when interest rates rise or fall. The longer a bond’s maturity, the greater the impact a change in interest rates will have on its price.
Pre payment Risk: Pre payment risk is the risk that the issuer of the bond/security will repay the principal prior to the maturity date. This will affect the payment schedule of the bonds. Investors may be compelled to re invest the proceeds at prevailing rates which may be lower than what they were earning earlier.