Fixed Income Securities

Have you ever wondered why some bonds are considered safer investments than others? Why do some bond issuers carry more risk than others? As an investor, it is important to understand the risks involved with different bond issuers before putting your hard-earned money into fixed-income securities.  

This article aims to provide investors with a comprehensive guide on issuer risk associated with different types of bonds. It explains fixed-income securities, the various kinds of bonds available in the market, and the factors influencing their risk and returns. Real-life examples of fixed-income securities are also discussed to give readers a practical perspective. 

What are Fixed-Income Securities?

Fixed-income securities, or bonds, are essentially loans provided by investors to governments, companies or other entities. When you purchase a bond, you are lending money to the bond issuer for a defined period, usually 5 to 30 years.  

In return, the issuer agrees to repay the principal amount at the time of maturity and provide regular interest payments during the bond term. The interest rate of the bond is fixed when it is issued. Some common examples of fixed-income securities include treasury bonds, corporate bonds, municipal bonds, etc. Fixed-income securities provide regular income through interest payments and capital preservation if held till maturity.

Understanding Fixed-Income Securities

Now that we know bonds are essentially loans, it is important to understand the different parties involved – the bond issuer who borrows the money. These bondholders lend the money and the collateral backing the bond. The key feature of any fixed-income security is the promise by the issuer to pay a specified interest rate and return the principal amount on the maturity date.  

However, the ability of the issuer to make timely interest and principal payments depends on their creditworthiness and financial health. If the issuer faces bankruptcy, the bondholders may lose part or all their principal. Therefore, investors must evaluate the riskiness of different issuers before putting their funds in fixed-income securities. 

Types of Fixed-Income Securities

• Treasury Bonds: These are fixed-income securities issued by the government to fund its budget. Treasuries are considered the safest option with minimal default risk. 

• Corporate Bonds: Bonds issued by companies across sectors to raise capital. Risk level depends on credit ratings and the financial health of the issuer. 

• Municipal Bonds: State and local governments issued bonds to finance public projects like infrastructure, transportation, etc. These are also relatively safe options. 

• Agency Bonds: Fixed-income securities guaranteed by government-sponsored entities like Fannie Mae, Freddie Mac, etc. They generally carry shallow credit risk. 

• Mortgage-Backed Securities: Bonds backed by a portfolio of mortgages and cash flows from mortgage repayments by homeowners. The risk depends on the quality of underlying loans. 

• Asset-Backed Securities: Fixed-income investments backed by loans, leases, credit cards etc. The level of risk depends on cash flows from customers’ repayments. 

• International Bonds: Bonds issued outside the US in foreign currencies by international entities. These provide diversification, as well as currency and overseas risk. 

Risk and Return of Fixed-Income Securities

As with any investment, fixed-income securities involve certain risks and the potential for variable returns. The two main risks investors face with bonds are credit risk and interest rate risk. Credit risk refers to the ability of the issuer to make timely principal and interest payments on the bond.  

Issuers with lower credit ratings have higher chances of default. Interest rate risk means the price of existing bonds may fall when market rates rise. Typically, longer-term bonds have higher interest rate risk. However, the risk-return profile varies across different bond types. Generally, bonds with higher credit risk offer higher yields.  

Treasuries have the lowest risk but also the lowest potential returns. The risk and corresponding yields must be weighed carefully based on the investor’s goals and risk tolerance. 

Examples of Fixed-Income Securities

To understand issuer risk better, let us look at examples of bonds from different categories:  

Treasury bond: The 10-year US Treasury note is considered extremely safe as the US government backs it. The lowest yields are around 2-3% at present.

Municipal bond:  General obligation bond issued by California to construct roads. Considered safe as taxes are pledged to repay. Yields around 3-3.5%, depending on the term.

Corporate bond:  ‘A’ rated bond issued by technology major Amazon for expansion. They are somewhat riskier than government bonds, but the chances of default are still low. Yield around 4-4.5%.

High yield bond:  ‘BB’ rated bond issued by an airline company for fleet purchase. Riskiest in investment-grade ratings. There is a higher chance of default. Yields around 6-7%. 

Conclusion

In conclusion, the credit risk of the bond issuer is a critical factor in determining the risk and potential returns from fixed-income securities. By understanding the different types of issuers and analysing their financial strength, investors can make well-informed decisions to build a diversified portfolio per their risk profile and time horizon.  

While government bonds offer maximum safety, other bond categories can potentially generate higher income if due diligence is conducted. Awareness of issuer risk is key to preserving capital and attaining investment goals through fixed-income instruments. 

Frequently Asked Questions