- What are Fixed Rate Bonds?
- How Do Fixed Rate Bonds Work?
- What are the Advantages of Investing in Fixed Rate Bonds?
- What are the Disadvantages of Investing in Fixed Rate Bonds?
- Who Should Invest in Fixed Rate Bonds?
- What are Floating Rate Bonds?
- What is the Difference Between Fixed Rate Bonds and Floating Rate Bonds?
- Frequently Asked Questions
Bonds are a type of debt instrument in which the investor loans money to an entity. The entity borrows money at a fixed interest rate for a specific time duration where an entity can be government, banks or corporates. One such type of bond issued by these entities is fixed rate bonds.
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What are Fixed Rate Bonds?
Fixed rate bonds, also known as fixed income securities, is a type of debt instrument which guarantees a fixed income. These bonds have a fixed interest rate throughout the term and a maturity period. In other words, the payments of interest are known in advance. Therefore, fixed income security offer investors a reliable stream of fixed interest payments known as coupon payments.
Both government and private companies issue these bonds. They can be short term or long term bonds. The government or companies issue these bonds to raise the capital they need for financing their business operations. The government issues a bond for a specific price and a fixed tenure, where the investor purchases it. In return, they offer regular interest payments to the investor. Finally, they return the investment at the bond’s maturity. In other words, the face value is the amount the investor will receive when the bond matures.
Fixed rate bonds are for those investors who intend to generate guaranteed interest rates for a given tenure. Further, investment in these bonds extends robust protection to the deposited amount. Hence, when the bonds mature, the bondholders receive the initial principal amount along with the interest. Moreover, long term bonds yield higher interest rates in comparison to short term bonds.
How Do Fixed Rate Bonds Work?
Fixed rate bonds are a debt instrument that is one of the popular asset classes that investors are aware of apart from stocks (equities) and cash and cash equivalents.
When the borrower (government) issues fixed rate bonds to the lender, both parties enter into an agreement. The issuer of the bond promises to pay back the principal amount on the maturity date. Also, the issuer pays interest on the money borrowed (coupon payment) throughout the tenure of the loan period.
For instance, the bond‘s face value is INR 1,000. The issuer will fix the coupon rate. However, the market price or issue price of the bond will depend on the credit quality of the borrower, holding period until maturity, and the coupon rate.
A fixed rate bond includes all the details of the amount borrowed, the date of maturity on which the money will be paid back to the investor, and details of coupon payments, including the coupon rate. Once the fixed rate bonds are issued, the bondholders are entitled to receive interest annually or semi-annually or monthly. And upon maturity, the bondholder will receive the face value (principal amount). They can either withdraw the money or transfer it to another account. Also, they can consider reinvesting the same into another account based on the terms mentioned on the debt instrument.
For example, A fixed-rate bond was issued on 2nd June in 2009 for a term of 10 years with its maturity date being 2nd June 2019. The coupon rate for it was 8.15%, and it was paid out on a half-yearly basis on the face value in December and June of every year.
What are the Advantages of Investing in Fixed Rate Bonds?
- Fixed Returns: One of the major benefits of fixed rate bonds is that investors are aware of the interest they will earn on their deposit for a fixed investment tenure. Also, upon maturity, the principal amount (face value) of the bond is paid back to the investor. Furthermore, in comparison to other fixed saving options, investing in fixed rate bonds offer better returns.
- Low Risk: In comparison to stock market instruments, fixed rate bonds are less risky. The reason is, bonds can overcome market volatility (For eg: market recession). As a result, this can help investors to develop a better financial plan and align the same to the achievement of their financial goals.
- Safety: The Credit rating agencies rate these bonds based on their creditworthiness. However, corporate bonds are riskier than government bonds. Thus, investment in fixed rate bonds guarantees both interest and principal repayment to the investor. Government bonds carry zero risk where the investor will not lose its money. While corporate bonds carry risk, where the risk can be managed by investing in high rated securities.
- Diversification: Investing in fixed rate bonds helps in balancing the portfolio with equity. The fixed return helps in balancing the market volatility. Hence, these bonds serve as an avenue for parking money as the investor’s needs and requirements. They can choose a tenure that matches their financial goal. Thus, this will help to develop a better financial plan for the investor.
What are the Disadvantages of Investing in Fixed Rate Bonds?
The following are the disadvantages of investing in fixed rate bonds with different types of risk associated with them –
- Credit Risk: Credit risk arises when the borrower is unable to repay the principal and interest amount. This risk can be reduced by investing in high rated fixed income securities. Also, one can choose fixed rate government bonds that have zero default risk.
- Interest Rate Risk: When inflation rises, the investors may lose out in generating attractive returns. Also, bond prices are indirectly proportional to the interest rate. In other words, when the bond prices rise, the interest rates fall, and when bond prices fall when the interest rate rises. Furthermore, the bond price at the time of maturity might be lesser than the price at the time of issue. Often, the long term bonds are more likely to be associated with inflation risk as the rate keeps changing frequently.
- Liquidity Risk: Liquidity risk arises when the investor is not able to sell the asset quickly. Generally, these bonds are illiquid in nature i.e there may not be an active market where investors can sell their investment. Also, some bonds may have a lock-in period before which they cannot exit. Even though government securities carry high liquidity, one has to pay a penalty if they wish to withdraw money prematurely from fixed rate bonds.
Who Should Invest in Fixed Rate Bonds?
Fixed rate bonds are one of the safest investments in India. It is suitable for investors who have a low-risk tolerance level and prefer safety in their investment. Usually, investing in market-linked instruments (like stocks), there is the uncertainty of capital appreciation. Hence, these bonds also act as a long term investment option for investors who do not have experience in investing in the stock market.
Typically, fixed income securities carry less risk. These securities can be a good option for investors who have less time to recoup the losses. However, one should consider the inflation risk, which can cause the investments to lose value over time. Also, investing in fixed rate bonds can help investors generate a steady source of income.
To conclude, investors who intend to generate steady and fixed returns over a fixed tenure may find this bond suitable. It will help to grow investments over time to save for retirement or other long term goals. Also, it helps an investor to dilute/diversify their portfolio through investment in these bonds.
What are Floating Rate Bonds?
Floating rate bonds are those that have a variable coupon rate. The coupon rates of these bonds are linked to market interest rates. The interest rate of a floating rate bond is linked to a benchmark rate which is reset at regular intervals. To understand better, one can draw its parallel with a floating-rate home loan. Whenever the repo rates rise, one has to pay a higher interest rate (and EMI) and vice versa. Similarly, an investor can benefit or lose out from any changes in coupon rates of floating-rate bonds.
In regular bond funds, whenever the interest rate rises, the price of the bond falls. It reflects a new higher bond yield. In contrast, the floating rate bonds have floating coupons which are in sync with the market rates. So, whenever there is a hike in interest rates, only its coupon rates increase without correction in bond prices. Thus, giving better yields to the investor. Similarly, when the interest rates fall, the coupon rates also fall reducing the yields to the investor. Therefore, investors should choose to invest in these bonds when the interest rates are low and are going to rise in future.
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What is the Difference Between Fixed Rate Bonds and Floating Rate Bonds?
The following table shows the difference between fixed rate bonds and floating rate bonds –
|Parameter||Fixed Rate Bond||Floating Rate Bond|
|Meaning||These bonds are known as fixed rate bonds as the interest rates remain fixed throughout the tenure.||These bonds are known as floating rate bonds as the interest rates tend to fluctuate throughout the tenure.|
|Interest Rate Risk||A fixed rate bond is very sensitive to the interest rate risk.||Floating rate bonds do not expose investors’ deposits to interest rate risk.|
|Maturity Amount||Investors are aware of the final amount they will receive at the end of maturity.||Investors find it challenging to ascertain the final maturity amount due to the variable interest rates.|
|Coupon||Investors receive a fixed coupon payment either monthly, half-yearly or yearly throughout the investment tenure.||Investors receive a variable coupon rate throughout the investment tenure i.e, when the interest rate rises, the coupon rates also increase and vice versa.|
|Financial Planning||Investing in fixed rate bonds helps in proper financial planning and it helps in aligning the investment to a financial goal.||One can build a proper financial plan with floating rate bonds as the returns may or may not align with a specific financial goal.|
The decision to choose either fixed rate bonds or floating rate bonds should be based on facts and features rather than the preferences of the investor. What works for some investors might not work for everyone. Therefore, considerations need to be made based on individual circumstances. They must consider their financial goals and the ability to bear the interest rate risk associated with these bonds before estimating the returns.
Frequently Asked Questions
Fixed rate bonds are also known as fixed income securities and are considered to be a safe investment option for an investor’s portfolio. Investors who intend to generate a guaranteed interest rate for a given term can invest in these bonds. Upon maturity, the bondholders receive the principal amount along with the interest payment. Investors with a low-risk tolerance level and a good understanding of risk can invest in bonds to build a diversified portfolio. Moreover, most of the government bonds issued in India are fixed rate bonds.
The major disadvantage of investing in fixed rate bonds is interest rate risk and market volatility. Investors may lose out in generating attractive returns when the inflation rises. Also, bond prices are indirectly proportional to the interest rate. In other words, bond prices rise when rates fall, and bond prices fall when the rate rises.
In comparison to stocks, bonds are less volatile and safer. Bonds represent debt and stocks represent equity. Bonds are subjected to fixed interest rate payment at the time of issuing the bond. Whereas for stocks, there is no guarantee that the value of the stock will increase. Also, the performance of the stock depends on the profitability and performance of the company. Furthermore, the interest rate of bonds is higher than the savings accounts. Moreover, the creditors have a preference over the equity shareholders. For instance, if a company goes bankrupt, the creditors are paid first. In contrast, equity shareholders lose their entire investment. Therefore, investors must choose the asset allocation towards bonds and stocks wisely. The asset allocation must be decided based on their financial goals and requirements.
Usually, bonds are considered a risk-free investment instrument. This is because there is a guarantee of principal and interest rate payment on maturity. However, one can also lose money in case of selling the bond before maturity. The losses incurred are subject to the selling price of the bond and the penalty mentioned in the bond agreement. Also, the investor may lose money from the bond in case the bond issuer defaults the payment. Hence, the investor should check the credit rating of the bonds before investing in them.