Fixed Income Securities

A simple analogy for the fixed income securities or bonds is that if you borrow from a bank to buy a car, your repayment installments will consist of the principle and interest payments. Now, in the case of buying bonds, you become the lender and you will be entitled to the principle plus the interest amount. Bonds are there for debt instruments issued by the borrower such as governments or companies. They pay a periodic stream of interest income. Upon maturity, bonds are redeemed at the face value. Some bonds have a callable feature that gives investors an option to redeem the bond before the maturity date. This usually happens when the market interest rates drop ad loans are cheaper.

The advantages of bonds are that they can produce a steady stream of income. For the investor, there is a certainty of cash flows. Bonds can be used as a vehicle to diversify the portfolio of investment assets to help reduce risk. There are some risks as well, associated with the bonds. There is an interest rate risk. When interest rates rise, bond prices will fall. Thus, investors can suffer a capital loss. There is, obviously, a default risk or credit risk for the investors. This is that the bond issuer fails to make timely payments or fails to repay the principle amount. Currency risk is another risk. Bonds denominated in foreign currencies expose investors to risk of adverse currency movements. Bond prices will also fluctuate with changing market conditions. There are some other risks as well.

What are the considerations to be made when selecting fixed income securities or bonds? The credit quality of the issuer and the events that can affect or erode the credit strength must be taken into account. Next evaluate the coupon rate of the bonds and the general level of interest rates. Another factor to look at is the length of the term to maturity. Also note that bonds can have embedded options, for example, callability is advantageous to issuer while convertibility to shares may be an advantage to the investors.

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