Fixed income securities are an important investment asset: government bonds and corporate bonds are valued according to the risk of default, duration and maturity.
A fixed income security is a debt instrument that entitles the holder to have a fixed flow of payments: these are corporate bonds and governement bonds. Usually this pre-established payment flow includes periodic interest (coupons) and the repayment of principal at its nominal value. In the case of “zero-coupon bonds“, the right is to have the nominal value repaid at maturity in a single solution.
Bonds are fixed income investments
Bonds are called fixed income security because the remuneration promised to the investor is predefined – both in size and timing – and does not depend on the level of profitability of the issuer, as is the case for the shares.
Warning: the coupon can be predefined in absolute terms or in relative terms. In the first case, the investor immediately knows the exact amount of the cash flows that he will receive against the loan granted (fixed rate securities). In the second case, however, the investor knows the parameter on the basis of which the cash flows in his favor will be defined, but he does not know the exact value (variable rate securities).
Whether they are fixed rate or variable rate, they are always fixed income bonds because the coupon is periodic.
By investing in bonds, you become creditor to the issuer: a State, a bank or a company. Unfortunately, since 2001 (Argentina default) it has been possible to realize that bond investments also require certain knowledge and careful considerations.
Let’s see the main factors that determine the return and risk of fixed income investments such as bonds: risk of default (or risk of insolvency), duration, maturity. In the article Liquidity risk of a financial instrument I described the liquidity of a security, the possibility of buying or selling a security without significant price variations, which also concerns the stock market.
Main characteristics of fixed income investments
Insolvency risk (default risk)
Usually, the higher the probability of default by the issuer and the higher the return on the security. To assess the risk of default, investors use the rating, an index that summarizes the quality of the issuer: the higher the rating, the lower the yield of the security.
The rating is not enough to guarantee the investor from the risk of insolvency (see Parmalat in Italy and Lehman Brothers in the United States), the only effective strategy to reduce the risk of insolvency is not to invest in a single issuer with significant shares of its own financial assets.
The duration of a security is a measure widely used in fixed-income bond markets to assess the risks associated with any changes in interest rates. Duration is also considered as an approximate measure of the volatility of a bond: a high duration indicates lower risks but higher returns, and vice versa.
The duration is expressed in days and years and provides, at a given moment in the life of a fixed income investment, the time necessary for it to repay, with the coupons, the capital initially invested.
Therefore an increase in the frequency or yield of coupons reduces the duration. For government securities, for example, an increase in interest rates (by the central bank of reference) implies a drop in bond prices and therefore an impact on investment performance and an increase in duration (of time necessary to repay the invested capital). A growth of two percentage points can lead to losses of 40 percent on a 30-year government bond.
The maturity of a bond, other things being equal (risk of insolvency and liquidity), makes the yields of similar bonds vary according to their duration in terms of time (which is different from the duration described above).
The differences between rates on instruments of different maturity issued by operators without risk of insolvency are usually represented in the figure:
Interest rates and bond maturity: the yield curve generally has a positive slope (normal) and indicates a gradual increase in interest rates with the extension of the maturity, up to a gradual flattening for very long durations. If the positive slope of the curve is excessive, there are expectations of rate hikes, while a negative slope means an unusual situation of higher short-term rates compared to long-term rates (i.e. a future drop in the level of interest rates).
For government bonds, short-term rates are usually dominated by money market operations by the central bank, long-term rates are predominantly influenced by market forces (private sector long-term demand for funds, future expectations inflation rate trend etc …).