Fixed Income investing involves the purchase of various debt securities issued by corporations and governments alike. Such securities are popular for their low-risk association and periodic interest payments. People mainly invest in this asset class to hedge their capital against market risks and earn a fixed payout at regular intervals.
Diversification of Portfolio: Types of Fixed Income Investments
Fixed Income securities are issued by publicly traded companies and federal, state, and local governments or municipalities. Government securities carry a nominal amount of risk, as they are backed by central or state governments that assume the liability ultimately. Hence, these securities are issued at relatively lower interest rates, often known as the benchmark interest rates.
Types of Government Securities
Treasury Bonds – Long-term security issued by the federal government, with maturity periods within 10 -30 years.
Treasury Notes – Medium-term security issued by the federal government, with maturity periods within 1 and 10 years.
Treasury Bills – Short-term securities issued by the federal government, with maturity periods of less than a year.
Treasury Inflation-Protected Securities (TIPS) – Treasury bonds issued by the government that are indexed to inflation to provide protection against declining purchasing power of money.
Municipal Bonds – Issued by state governments or local municipalities to fund new projects.
Publicly traded companies also issue a plethora of instruments to raise debt for multiple purposes. However, corporate bonds can be categorized into two types – investment-grade bonds and junk bonds. Investment-grade bonds have a lower risk of default, as assets or third-party guarantees back them, and hence have relatively lower coupon (interest) rates. On the other hand, Junk bonds are issued at higher interest rates due to the higher risk factors.
Types of Corporate Bonds
Commercial Paper – Short-term debt raised to finance the day-to-day operations of a company, generally having a maturity period of fewer than 270 days.
Secured and Unsecured Senior Notes – Long-term debt raised to fund expenses and business growth opportunities. Senior notes backed by assets are known as secured senior notes and tend to have relatively lower interest rates than standalone, unsecured senior notes.
Collateral Trust Bond – These are bonds issued by one or more financial assets such as equity or other debt instruments.
Equipment Trust Certificates – Debt backed by newly acquired physical assets (equipment). Revenues generated from the use of the equipment are used to retire the debt over time.
Risks Associated with Fixed Income Securities
Fixed income investments generate nominal returns compared to the stock markets. Such instruments are popular for the diversification of investment portfolios and among risk-averse investors. Also, people reliant on timely interest payouts prefer bonds with annual or periodic coupon payments.
Companies are required to address all their debt obligations before calculating the return for shareholders. Thus, debt instruments are much safer compared to equity investments. On the other hand, government bonds are known as “risk-free” investments, as federal authorities assume any liability.
The yields on government bonds are customarily known as “benchmark” yields, as it forms the basis for calculating interest on corporate bonds.
The risk associated with fixed income instruments can be broadly categorized into the following types –
The risk of default is one of the significant risks associated with debt investments. While Treasury notes have virtually no credit risk, corporate bonds are subject to high credit risk and are issued at higher interest rates than government securities.
Popular credit rating agencies such as S&P Global Ratings, Moody’s, and Fitch Ratings categorize corporate bonds based on multiple factors to distinguish investment grade (high rating) bonds from high-yield junk (low rating) bonds.
Investing in secured bonds (backed by collateral) offsets credit risk substantially, as, in the event of default, the asset is liquidated to repay the bondholders. Also, debt with a high seniority ranking carries lower risks as companies are obligated to retire senior-issued debt first.
Bondholders can sign negative covenants written into the bond indenture to reduce credit risks. These covenants dictate specific terms for underlying companies to follow and reduce the chances of default. Usually, negative covenants restrict companies from issuing additional debt or pay dividends more than the stipulated contractual limit.
Interest Rate Risk
Longer-term bonds generally have higher interest rates compared to short-term bonds, given the underlying market risks. As the probability of market interest sets changing over an extended period is much higher, long-term bonds have higher stated interest rates to accommodate such market volatility.
Also, long-term bond yields are more susceptible to a change in benchmark interest rates than short-term bonds, as people are likely to swap long-term bonds with a lower interest rate if the market rates change.
Alternatively, investors can opt for floating rate notes (FRNs) to mitigate interest rate risk. Such notes generally offer a pre-determined spread over benchmark interest rates. Most coupon rates of FRNs are calculated based on the current LIBOR (London Interbank Offer Rate) plus spread, revised semi-annually.
While fixed-income investors favor short-and-medium-term bonds, they are often associated with reinvestment risk, particularly relevant in a low and declining interest environment. Moreover, embedded call options bonds are frequently used by companies, which allow them to repurchase their debt at any time.
Generally, such call options are executed when the market interest rates decline, allowing companies to retire their existing debt at higher interest rates, and issue new debt securities at market rates, thereby reducing their interest burden. It leaves investors vulnerable to reinvestment risk, as they need to reinvest their capital into newly issued securities having lower coupon rates.
Debt investors can opt for bonds having a make-whole call provision, which requires companies to make a lump sum payment to bondholders while retiring the debt. Corporations also issue putable bonds, which give bondholders the right, but not the obligation to sell the bond to the issuer, at a predetermined price and date. These bonds are favored by debt holders owing to their added benefits. Thus, putable bonds are generally priced higher than a standard bond and have lower yields than lower risk.
Most government and corporate bonds are issued at fixed interest rates, making them prone to inflation risk. As the aggregate price levels rise over time, the real value of coupon payments declines, thereby reducing the real return to bondholders. Bonds with a higher maturity period have higher inflation risk than short-term bonds, as the inflation rates appreciate substantially over time.
Investing in FRNs can help investors hedge such inflation risk, as the interest payouts are adjusted periodically depending on the market interest rates. However, FRNs carry a greater degree of risk than standard vanilla bonds, as the coupon payments decline in the event of falling market rates. The United States also issues inflation-protected securities (TIPS) to hedge the corresponding inflation risk, as the rates are indexed to the prevailing price levels.
Invest in bond mutual funds or ETFs to diversify risks
Every investment carries certain risks. You need to speak to a certified investment manager in order to chalk out an investment strategy that will help you achieve your financial goals. Diversification is key to any investment strategy as it minimizes your overall risk by a significant margin.
One way to achieve diversification in fixed-income securities is to purchase bond mutual funds or ETFs which will provide you exposure to a basket of instruments across categories.
You need to consider several factors while investing in a bond mutual fund including the yield and maturity date.
A bond instrument’s maturity date is basically the time when the principal of the investment will be paid back to investors.
Bond Market Today
Bond markets are typically significantly larger than equity markets. The United States market for investment bonds has been approximately 79% larger than the equity markets over the past 25 years. The United States corporate bond market is currently valued at $10.50 trillion as of the fourth quarter of 2020, making it the highest in history.
Government debt is also near all-time highs, as countries have been deploying expansionary fiscal and monetary policies to combat the coronavirus pandemic induced recession. The United States spent more than $6.50 trillion in 2020 through stimulus package approvals and tax deferrals, marking a 47% increase year-over-year.
The Federal Reserve plans on keeping the interest rates unchanged to near-zero levels over the next couple of years, with the first hike anticipated in 2023. This should keep the overall cost of borrowing tremendously low for the foreseeable future, thereby allowing the debt markets to remain subdued in the near-term.
Furthermore, the Fed’s quantitative easing policies involving the purchase of approximately $80 billion worth of government and corporate debt purchases pushed overall debt to all-time highs. The Eurozone also witnessed a substantial uptick in their debt levels, as countries are borrowing to fund their economic revival. The average government debt of 11 European countries jumped 11% to €11.10 trillion in 2020, amounting to 97% of the total GDP.
While the lower interest rates have discouraged debt investments over the past year, bond markets are making a solid comeback as yields are rising amid volatile stock markets. Benchmark US Treasury yields rose to one-year highs earlier in March and are expected to rise further in the upcoming months. The surging inflation rates and strengthening of the greenback are expected to be major drivers boosting the bond markets further in the forthcoming months.