Fixed-Interest Security

Published Apr 29, 2024

Definition of Fixed-Interest Security

A fixed-interest security refers to a type of investment that pays out a set amount of interest to investors at regular intervals until its maturity date. Upon maturity, the principal amount (the initial investment) is paid back to the investor. These securities are typically issued by corporations, governments, and other entities to raise funds for various purposes. Fixed-interest securities are considered a relatively safe investment compared to stocks, as they provide consistent income and return of principal is guaranteed, assuming the issuer does not default.

Example

Consider a government treasury bond, a common type of fixed-interest security. If an investor purchases a treasury bond with a face value of $1,000 and an annual interest rate (coupon rate) of 5%, the investor will receive $50 in interest payments every year until the bond matures. If the bond has a maturity of 10 years, at the end of the 10th year, the investor will receive the final interest payment along with the $1,000 principal amount.

This predictable stream of payments makes fixed-interest securities attractive to investors seeking regular income, such as retirees, or those looking to preserve capital while earning a return on their investment.

Why Fixed-Interest Security Matters

Fixed-interest securities play a crucial role in the financial markets and offer several benefits to both investors and issuers. For investors, they provide a stable and predictable source of income along with a lower risk profile compared to equities. This makes them an essential component of a diversified investment portfolio, especially for risk-averse investors or those with specific income requirements.

For issuers, issuing fixed-interest securities allows them to raise capital with the certainty of fixed borrowing costs. This is especially important for governments and corporations that need funding for long-term projects or to manage their cash flow.

Moreover, fixed-interest securities contribute to the overall liquidity of the financial markets. They are widely traded, allowing investors to buy and sell them before maturity, although the price may vary based on changes in interest rates or the creditworthiness of the issuer.

Frequently Asked Questions (FAQ)

What happens to fixed-interest securities when interest rates change?

The market value of fixed-interest securities is inversely related to movements in interest rates. When interest rates rise, the value of existing fixed-interest securities tends to fall since new issues come with higher interest rates, making the old ones less attractive. Conversely, when interest rates fall, the value of existing securities tends to increase as they pay higher interest than new issues. However, these price changes primarily affect investors who buy or sell fixed-interest securities in the secondary market; investors holding securities to maturity will still receive their fixed payments and principal as agreed.

Can fixed-interest securities default?

Yes, there is a risk that the issuer of a fixed-interest security might not be able to make timely interest payments or return the principal at maturity. This risk, known as default risk, is higher with corporate bonds compared to government bonds, especially with issuers in unstable financial conditions. Investors typically assess the credit rating of a bond, issued by credit rating agencies, to gauge the default risk before investing.

How do investors choose which fixed-interest securities to invest in?

Investors consider several factors when choosing fixed-interest securities, including the interest rate, maturity date, and the issuer’s creditworthiness. A higher interest rate generally implies a higher risk, so investors seek a balance between the yield and the risk they are willing to accept. The maturity period also affects the choice, as longer maturities usually offer higher yields but carry more risk, particularly from changes in interest rates. Finally, the issuer’s credit rating provides insight into its financial stability and likelihood of fulfilling its obligations.