Fixed-Income Securities: An Overview
Defining Fixed-Income Securities
Fixed-income securities, commonly known as bonds, represent a loan made by an investor to a borrower (typically a corporation or government). The borrower agrees to pay back the principal amount (the face value or par value) at a specified maturity date and to make periodic interest payments (coupon payments) at a predetermined rate.
Types of Fixed-Income Securities
- Government Bonds: Issued by national governments, generally considered low-risk due to the backing of the government.
- Corporate Bonds: Issued by corporations to raise capital for various purposes. Their risk level varies depending on the issuer's financial health.
- Municipal Bonds: Issued by state and local governments to finance public projects. Interest income may be tax-exempt at the federal level.
- Zero-Coupon Bonds: Do not pay periodic interest; instead, they are sold at a discount and mature at face value.
Key Characteristics of Bonds
Yield to Maturity (YTM):
The total return anticipated on a bond if it is held until it matures. It considers the bond's current market price, par value, coupon rate, and time to maturity.
Coupon Rate:
The annual interest rate paid on the bond's face value. It is expressed as a percentage.
Maturity Date:
The date when the principal amount of the bond is repaid to the investor.
Credit Rating:
An assessment of the issuer's creditworthiness by credit rating agencies. Higher ratings indicate lower risk.
Interest Rate Risk:
The risk that bond prices will decline as interest rates rise. Bonds with longer maturities are more sensitive to interest rate changes.
Inflation Risk:
The risk that inflation will erode the purchasing power of the bond's future cash flows.
Bond Valuation
The value of a bond is determined by discounting its future cash flows (coupon payments and principal repayment) back to the present using a discount rate that reflects the prevailing market interest rates and the bond's risk profile.
Investing in Bonds
Bonds can be purchased through brokerage accounts. Investors should carefully consider their risk tolerance, investment goals, and the characteristics of individual bonds before making investment decisions.