Bonds are indeed a prime example of fixed income investments. When investing in bonds, an individual essentially lends a specific amount of money to the bond issuer, which can be a corporation or a government entity. Bonds are commonly issued by various companies, as well as national, regional, and local governments, as a means of borrowing funds at reasonable rates and payment terms.
One significant advantage of borrowing through bond issuance, compared to traditional borrowing methods, is that the principal amount does not need to be repaid in installments. Typically, bonds are repaid in full at maturity, with interest payments made periodically throughout the bond’s term.
This characteristic allows the bond issuer to retain the full principal amount of the loan over the bond’s duration, eliminating the need to continually seek additional borrowing if they require access to the bond amount on an ongoing basis. Once a series of bonds reaches maturity, it can be rolled over by issuing a new series of bonds.
By managing borrowing in this way, the bond issuer can handle a specific amount of debt efficiently over time. However, in most cases, the bond issuer relinquishes the option to pay down the principal during the life of the bond. In contrast, with a traditional loan, borrowers usually have the flexibility to pay it off at any time if they desire and have the means to do so. While some bonds may offer this feature, it is not common, and most bonds are not callable.
If interest rates decrease, bond issuers may regret paying interest in bonds that exceed prevailing market rates. However, they are generally locked into those rates. Conversely, if interest rates rise, having locked in a lower rate through the bond issuance becomes advantageous.
The dynamics of interest rates can impact bond issuers’ perspectives on their interest payments. If rates decline, bond issuers may find themselves paying interest that is higher than the prevailing market rates. On the other hand, if rates increase, having secured a lower rate through the bond issuance becomes beneficial.
Fixed Income Investments: A Key Advantage – Rate Security
The nature of bonds provides security for both bond issuers and investors. There are two types of risks involved: absolute fluctuations in interest payments and opportunity costs.
Absolute risk pertains to situations where it would cost more to borrow during the life of the debt instrument. This is the case with variable-rate instruments, where an increase in interest rates results in higher out-of-pocket interest expenses.
Opportunity cost risk refers to the possibility that, by locking in a specific rate, one may miss out on borrowing money at a cheaper rate in the future or utilizing a variable rate tied to the interest rate market. Both types of risks carry real consequences, but the absolute risk that directly affects one’s expenses tends to have a more pronounced impact.
If you have the option to purchase something at a known price now or enter an arrangement where the price will be determined later by the market, there is a risk that the price may rise beyond your affordability. Similarly, with interest rates, bond issuers often prefer the certainty of a known interest rate over a specified period to provide stability to their operations.
Bondholders, particularly those relying on fixed income investments for personal income, also prefer the higher stability offered by fixed interest rates. If the income payments decrease significantly, it may impact their ability to maintain a comfortable lifestyle. Therefore, the stability of a predictable return is generally seen as advantageous.
Due to these reasons, fixed-rate bonds are considered preferable for income purposes. The preference for fixed interest rates by both bond issuers and bondholders contributes to the significant market size of fixed income investments.
When considering fixed income investments, the fixed level of income they provide is indeed a defining feature. However, it is equally crucial for this income to be as stable as possible, as income stability is the primary goal rather than simply any income.
Preferred Stock: Exploring its Role as a Fixed Income Investment
Another example of a fixed income investment is owning preferred shares in a company. While bonds are the most common form of fixed income investments, some investors opt to own preferred stock.
Preferred stock shares similarities with bonds rather than common stock. While common stock’s appreciation primarily comes from price fluctuations, preferred stock offers a more bond-like characteristic. Although common stock may pay dividends, these dividends are not guaranteed and are subject to the discretion of the company.
In contrast, preferred shares, like bonds, have an agreed-upon interest payment called the dividend rate. This fixed income amount is the primary return of the investment. While preferred shares represent ownership in a company, they function more as a loan to the shareholder, similar to bonds. While not a loan per se, preferred shares represent a preferred claim on the company’s income, with dividends paid as long as the company generates profits.
Valuation of preferred shares operates similarly to bonds, based on the opportunity cost of interest, weighing the cost of accessing funds today against the actual interest or dividend paid. However, the likelihood of a company maintaining its dividends can also influence the price of preferred shares. If a company struggles and cannot pay dividends to its preferred shareholders, the dividends owed are recorded as payments in arrears.
The ability of a company to sustain preferred dividends becomes a significant factor for preferred shareholders. A company facing financial difficulties and suspending preferred dividends indicates a higher risk that the dividend payments may not continue as planned. Conversely, a financially strong company is perceived as less likely to face difficulties in maintaining preferred share dividends.
This is somewhat analogous to the bond rating system, where changes in credit ratings can impact bond values. However, with preferred stock, the impact is more tangible as non-payment of dividends owed directly affects shareholders. While bond ratings may not concern bondholders who hold the bonds until maturity, the suspension of preferred dividends due to poor business conditions represents a significant event for preferred shareholders.
In the case of cumulative preferred shares, the company must catch up with the missed payments before resuming dividends to common shareholders. However, if the preferred shares are non-cumulative, preferred shareholders may lose their dividends.
In the event of company bankruptcy, the company’s creditors, including bondholders, are prioritized in receiving payment before preferred shareholders. While preferred shareholders have preference over common shareholders, by the time preferred shareholders have the opportunity to claim their assets, there may be little or nothing left for them to claim.
Bonds: A Superior Choice for Fixed Income Investing
When seeking a stable return, investors generally prefer bonds over preferred stock in fixed income investments. While there are other considerations to take into account when choosing between the two, the fact that bondholders are creditors who receive preferential treatment makes bonds more favorable for fixed income purposes.
This preference stems from the treatment of creditors in various scenarios, not just during company liquidation. Dividends must be paid out of profits, after all debts, including interest payments to bondholders, have been settled. Bondholders are given priority in receiving their payments, regardless of whether the company is profitable or not.
If a company fails to meet its obligations to preferred shareholders, it does not necessarily mean the company is insolvent. In contrast, interest payments to bondholders are typically honored unless the company goes bankrupt. The risk to preferred shareholders depends on the company’s financial strength, with stable and reliable companies being more likely to fulfill their dividend obligations.
Government bonds, which can be purchased by investors, tend to be more stable and reliable due to governments not being as susceptible to operating losses unless they are extreme. As a result, government bonds offer a high level of stability and reliability.
Constructing a fixed income portfolio involves more than just seeking stability, as more stable investments often offer lower interest rates. Many investors aim for a mix of both more and moderately stable investments. While they seek to keep risks low, they may not require them to be extremely low, such as with U.S. Treasuries. They may also seek to benefit from the better returns that moderately reliable investments can provide.
Balancing risks with returns is a significant aspect of constructing a fixed income portfolio, taking into consideration an investor’s specific income objectives. The desired returns play a crucial role in determining the appropriate mix of investments within the fixed income portfolio.
