What are Fixed Income Securities?
A fixed income security is a type of debt security that pays interest over a certain period of time.
The simplest way to look at understanding fixed income security is to think about it like a loan, with you being the issuer of the loan.
The borrower will be required to pay you interest for the life of the loan and then repay you the full loan amount at a date in the future known as maturity. The interest rate is normally fixed but can be floating, which means it changes based on some other benchmark.
Generally speaking, fixed income securities are a safe and reliable means of generating income which is why it is a popular choice for those with a lower risk tolerance or for those who are looking at ways of diversifying their portfolios.
There’s plenty of investment jargon that gets thrown around when we talk about fixed income securities, so let’s break them down in more detail starting with the three main types, and the top picks, of fixed income securities.
Three Main Types of Fixed Income Securities
There are three main types of fixed income securities which are traded on the ASX, including Australian Government Bonds, Corporate Bonds and Hybrid Securities.
We begin with traditional corporate bonds which are effectively a contractual obligation to pay – very similar to a loan. The issuer of a corporate bond is borrowing money, while the purchaser (investor) is providing capital for the company to use.
Companies issue bonds for a variety of reasons including business expansion, acquisitions, and to fund share repurchases and dividends. Bonds include:
- Short term bond
- Bond mutual funds
- Junk bond
- Individual bonds
- Treasure bond
- High yield bond
Corporate bonds are widely held in fixed income portfolios both in Australia and overseas. They are generally much safer than equities (shares) as they provide a contractual obligation to pay income, unlike dividends which can be reduced or stopped at any time. A diversified portfolio of high-quality bonds provides a regular, stable income stream, as well as materially better capital preservation (chance of getting your initial investment back) than seen in equity portfolios.
Countries and States also issue bonds to fund infrastructure projects and services to the people. These are known as government bonds such as the 30 Year US Treasury securities which are backed by the Commonwealth Government or municipal bonds which might be backed by the various states.
Hybrid securities are financial instruments that have both equity and debt features.
Generally speaking, a hybrid security will offer regular interest payments, much like a bond, however, they are often at higher rates than say a corporate bond. A hybrid security will also feature the ability to be converted into equity, such as an ordinary share, allowing investors the best of both worlds.
Types of Hybrid Securities
Hybrid Securities can at times be complicated because no two are the same. Every hybrid security comes with its own terms and this can make them difficult to compare for retail investors.
The three most common types of hybrid securities in Australia are convertible debt securities, preference shares and capital notes.
Convertible debt securities allow the holder to convert it to another type of security at a certain date in the future. This gives convertible debt securities an option-like characteristic as they can typically be converted into equity in the form of ordinary shares while also benefiting from the risk mitigation element of being debt-based.
Preference shares are like ordinary shares, however, they oftentimes will carry a specified dividend rate. That means investors who hold preference shares will know what type of return they will be getting, whether that is fixed or floating. They also normally carry a right to be redeemed for cash at maturity, making it similar in nature to a debt security like a bond.
Capital notes are debt instruments, however, they have equity-like features. For example, perpetual debt securities don’t mature much like a share. Subordinated debt securities rank beneath other forms of debt like ordinary shares do and might pay a higher interest rate as a result. While knock-out debt securities allow a third party like APRA, to extinguish them under certain circumstances.
How do Fixed Income Securities Work?
Fixed income securities work a lot like a normal loan which most people are familiar with. In exchange for providing a loan, investors expect to be paid interest over the life of the investment and to have their original capital returned at maturity. The terms of the arrangement are agreed in advance.
There are many conditions that must be agreed but two of the key ones are the length of the loan and the amount of interest to be paid. This can explain why it is called fixed income. The longer the term, the more interest borrowers have to pay. The riskier the borrower is perceived to be, the more interest they will have to pay.
Below is an example of a typical cash flow for a bond. An investor provides the borrower $100 on day one. If we assume a 5% agreed rate of interest, the investor would expect to receive their interest throughout the year at regular intervals.
In our example that is roughly 2.5% or $2.50 every six months. Then, at the end of the agreed period the investor receives their final $2.50 coupon, as well as the original $100 provided to the borrower.
Fixed Income Securities via Fixed Income ETFs
It’s possible to access fixed income securities either directly or through fixed income ETFs.
Investing directly in fixed income products such as exchange traded bonds is recommended for professional investors with experience and understanding of the individual product.
Investing by way of a fixed-income bond ETF allows you to invest in a number of different types of bonds and achieve a certain level of diversification in the process.
eInvest offers a number of fixed income ETFs to help diversify your overall portfolio and give investors exposure to a host of fixed income securities.
ECOR Fixed Income ETF
ECOR aims to provide investors with a steady stream of income and capital stability over the medium term, by investing in a diversified portfolio of fixed income securities and cash.
EMAX Fixed Income ETF
EMAX aims to provide investors with a monthly income stream by investing in a diversified portfolio of credit fixed income securities
Benefits of Fixed Income Securities
Generally speaking, fixed income investments are less volatile than equities. That’s because they ultimately need to be repaid at maturity meaning they maintain their value over a long period of time.
Because fixed income investments pay set interest (either fixed or floating) over their lifetime they are an excellent way to achieve predictable income for your portfolio.
Listed fixed income investments are traded on the ASX meaning they can be bought and sold at any time throughout their lifetime. Compared to other similar types of investments such as term deposits, where the investor’s money is tied up until maturity, fixed income securities and particularly ETFs offer a great combination of income and flexibility for investors.
Investors looking to diversify their portfolio away from shares can use fixed income to help add regular income and also protect against large moves in the equity markets. Fixed income securities and ETFs are a great way to help an investor achieve a balanced portfolio.
Risks of Fixed Income Securities
Compared to equities fixed income securities might not have the same level of liquidity. This can be an issue for investors looking to buy and sell quickly. This can be mitigated by using popular ETFs that generally see higher trading volumes than individual fixed income securities.
Interest Rate Risk
Fixed income securities and their price movements are very much linked to underlying interest rates. Changes in interest rates can negatively affect the rate and price which is similar to duration risk.
Credit Risk / Default Risk
While a fixed income security is a form of debt, there is still some risk the party issuing the security will not be able to meet their repayments or be able to pay the full principal amount at maturity. Generally, this is reflected in the interest rate an investor will receive as bonds might be classified as investment grade or junk depending on the perceived risk.
When deciding on investing strategies, retirement planning, estate planning, life insurance, real estate, and so on, there’s a lot you need to take into account. Your best bet is to do your research – starting with the bonds market and create a planning guide. Discuss your options with financial institutions and ensure you understand the risks associated. If you need to, use a retirement calculator, payment calculator or loans calculators to determine your income and assets. And finally, talk to a trusted financial advisor who can work with you throughout the entire process. Wealth management is imperative if you want a sound future.
Disclaimer: Please note that these are the views of the author, Jodi Pettersen, Investor Relations, eInvest and is not financial advice.
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