There are many investment vehicles and securities. Interestingly, these instruments have unique properties which make them suitable for one type of investment or the other. In the subsequent publications, as much as we can, we shall cover most of these securities. The list is quite a tall one so we may touch only on the most common. Herein, let us take a look at fixed income securities today.
Fixed income securities are a type of debt instrument. In simple terms, a certain amount of money is borrowed for a fixed period of time at a, usually, fixed interest rate. The borrower, referred to as the issuer of the security, promises to provide returns in the form of regular, or fixed, interest payments and repayment of the principal when the security reaches maturity. All terms and conditions of the debt are made known prior to the transfer of money to the borrower from the investor. The issuers may be governments, corporations, financial institutions and other entities which use the debt proceeds to finance their operations.
Fixed income securities differ from equity, as they do not entitle the lender (investor) with an ownership interest in the issuer, as equities do. However, they confer a seniority of claim, as compared to equity interests, in cases of bankruptcy or default. People who invest in fixed income securities are usually paid first before shareholders, so the risk of the debt instrument holder is lower than that of a shareholder.
There are a number of different types of these securities. Bills, notes, bonds, certificates of deposit, commercial paper, banker’s acceptance, repurchase agreements (repos) and mortgage-backed securities are all types of fixed income securities. In the more advanced jurisdictions, there are even more, like strip coupons and residuals, laddered portfolios, guaranteed investment certificates, etc. Some are distinguished by their periods of investment (tenors), like bills, notes and bonds. Some are defined by their structure and underlying assets, like mortgage-backed securities and some are a combination of more than one security to achieve a desired result, like repos.
Bills, Notes and Bonds
These are among the simplest forms of fixed income securities. The issuer of the security promises to pay a certain amount (percentage of the principal borrowed) or no amount periodically (weekly, monthly, quarterly, annually, etc.). They are differentiated by their tenors (periods of investments). Bills are usually issued for up to one year. Notes are issued for more than a year but less than five years in most economies. Bonds have the longest tenors, being issued usually for more than five years and sometimes for as long as a hundred years (century bonds). The most common forms are the bonds. The market for bonds stood at over $128 trillion, as of August 2020. Globally, they can be divided into two main parts according to their issuers: sovereigns, supranationals and agencies (SSA- governments/nations and their agencies) and corporates. The latter constitutes more than two-thirds of all bonds, globally. Issuers include some of the largest companies like Walt Disney, Coca Cola and Amazon, countries like Argentina, United States, Austria and China or supranationals and agencies like European Union and World Bank.
An intermediary- a bank, say, may put together a bundle of home mortgages with similar characteristics and sell as a mortgage-backed security to investors at a discount. There are two types:
- Pass-throughs – These are structured as trusts to receive mortgage payments from homeowners and make coupon payments to investors of the securities. Tenors are similar to the mortgages.
- Collateralized mortgage obligations – These consist of multiple pools of mortgages bundled together and sold as securities. Eg. shares in a special purpose vehicle that holds the pools of mortgages. They are divided into tranches according to risk classifications and maturities.
Certificates of Deposit
These are issued by financial institutions like banks, savings and loans companies and microfinance companies for varying tenors. They promise a certain amount of interest plus full principal repayment on maturity. They can be liquidated or recalled before maturity, though.
Issued by large (or credit-worthy) corporations for up to one-year, commercial paper is unsecured and proceeds are used to finance short-term obligations like working capital. It is usually issued at a discount from face value and reflects prevailing market interest rates. In recent times, Asset Backed Commercial Paper (ABCP) are growing in popularity but ACBP is normally issued by financial institutions as an intermediary instrument or a large corporation which has done several issues of debt instruments on the market.
A banker’s acceptance most commonly occurs in international trade transactions. It provides a bridge between an importer and an exporter when they do not have an established business relationship. A banker’s acceptance can be used by an importer to finance his purchases or can be created through a letter of credit transaction. An importer can raise a banker’s draft, present to a bank and receive money (at a discount) to pay suppliers. On or before the maturity of the security, the importer repays the face value of the acceptance to the bank.
Letters of Credit
Also used in international trade, they are issued by banks to promise payment to exporters. Upon presentation of an invoice and shipping documents with a time draft demanding payment, the bank accepts the time draft. The exporter can hold on to this agreed time draft or submit pre-maturity for payment (at a discount).
Repurchase Agreements (Repos)
This involves government issues only. A dealer would sell government securities to investors, usually on an overnight basis, and buy them back the following day at a slightly higher price.
Benefits of Investing in Fixed Income Securities
- Stable Returns– Fixed income securities offer stability of returns and predictability. They are therefore very useful for steady income generation or pensions planning and investment.
- Safety of Investment- For the same reason that they offer stable and predictable returns, the risk is low and probability of default is also low.
- Portfolio Diversification– Investment in fixed income securities offer a much-needed diversification to a concentrated portfolio of equities. To make an overall portfolio returns stable, it is imperative that a significant investment in highly rated debt securities is added.
- Seniority During Liquidation– When the company files for bankruptcy and goes for liquidation, it is liable to pay back to its debtors and stock holders. Lenders of the company, who hold corporate bonds of the firm get priority over those who hold equity. This is one more reason why debt securities are considered to be a safe investment avenue.
Risks of Investing in Fixed Income Securities.
Fixed income securities are relatively safe investments. They, however, have the following main risks associated with them:
- Interest Rate Risk – Changes in interest rates affect the security’s prices. Eg. For bonds, if the interest rates rise, bond prices fall and vice versa.
- Credit Risk- Credit risk arises when the issuer of the security defaults on the timely payments of interest and the principal amount.
- Exchange Rate Risk- The risk that cash flows from securities lose value after exchanging them for a different currency. Foreign investors of our local instruments are exposed to this type of risk.
- Volatility Risk- This is true for securities that have options embedded in them.
- Political or Legal Risk- This is the risk that a country’s political or legal environment may change to adversely affect investments in fixed income securities.
- Event Risk- An event risk refers to an unexpected event that decreases the value of a fixed income security. The two types of event risks are a natural or industrial accident, and corporate restructuring.
Factors to Consider When Investing in Fixed Income Securities
When we lend someone money which ought to be repaid later, we are concerned chiefly by the person’s ability and willingness to pay back, and on time as agreed. Credit risk, including sovereign risk, is an important consideration. We can carefully analyze the entity’s financials to try to gauge past credit worthiness to have an idea of how likely timely repayment will be. Otherwise, we can depend on credit rating agency reports or scores.
Interest rate risk is also a key consideration. What is the direction of rates? Is the size of the return of an existing investment being diminished by rising interest rates? Are interest rates likely to rise after the investment has been made? Are the timing and rate of the issue right and commensurate with rates on the market?
Of importance too is inflation: whether inflation is rising, dipping or staying the same during the life of the investment security. A rising rate of inflation could mean reduced real values of cash flows from an investment in a fixed income security.
When we engage in a cross-border investment in fixed income, we must take note of currency risk, especially in regimes where the local currency value fluctuates significantly within a short period. Depreciation of the currency of the security would mean a loss in value of investment.
Fixed income securities remain a key part of investment securities globally. Though the fixed income market in Ghana is relatively underdeveloped, there is continuous progress. These changes are intended to increase market depth and attraction, and situate the Ghanaian market for fixed income and one of the foremost emerging markets globally.
About the Writer
Kwadwo is a Senior Investment Analyst at OctaneDC Limited and heads OctaneDC Research. Prior to joining OctaneDC team, Kwadwo was a Fund Manager at Dalex Capital and has over a decade experience in fund management and administration, portfolio management, management consulting, operations management and process improvement. You may contact him at [email protected] or +233244563530