Investing in fixed income: Understanding fixed income securities

Highlights

• A fixed income security is an investment that provides a return in the form of fixed periodic interest payments through coupon payments.
• Eventually investors regain the whole principal once the security matures, unless default takes place.
• Unlike other forms of securities where payments change according to some underlying measure, payments of fixed income securities remain constant, while the amount is known in advance.
• Typically, fixed income instruments are issued by governments, corporations and other entities in order to finance their operations. Technically, these are classified as bonds.
• A good strategy for those looking to achieve capital preservation, fixed income investments serve as a steady source of income, while they are often considered low risk when compared to equity markets and other more complex financial instruments. In addition, they are rated by reputable credit rating agencies, while the wide variety of fixed income securities available means that you can easily diversify your portfolio.
• Some of the disadvantages include risk of inflation. In periods of rising inflation, fixed income securities are negatively impacted and capital will vary throughout the tenor of the bond. Nonetheless, capital will be re-paid in full on maturity unless a default occurs. Bearing in mind that fixed income is a long-term security, the principal amount will be tied for a number of years which affects liquidity.
• To tell if a fixed income security is worth investing in, you should analyse its credit risk, amongst other things. Companies that have manageable levels of debt, good earnings potential and good debt-paying records usually have good credit ratings.
• Categorised into short-term and long-term securities depending on the term of maturity after their issuing, fixed income products include treasury bills, government bonds, corporate bonds, high-yield bonds, fixed income mutual funds and fixed income ETFs.
• Calamatta Cuschieri has been offering fixed income instruments since 1972. As a result, we have gained extensive experience, while we have specialised analysts that track and have direct access to both local and global fixed income securities.
• Interested to invest in fixed income securities? Get in touch with one of our investment advisors to book an appointment and have a look at our full range of investment products.

A mainstay of investor portfolios, fixed income securities have become increasingly popular, especially with Maltese investors for being relatively safe and for offering market diversification, while the current yielding environment continues to be benevolent for the fixed-income asset class. This is more so when considering that over the past years interest rates in banks have been decimated by negative interest or base rate adjustments in major markets including the EU and Malta.

While fixed income securities come in several shapes and sizes, they are simple in principle – they offer reliable payouts on a fixed schedule that you can count on as an additional income source, while they are a great savings vehicles for when you do not want to put your money at risk.

Here we explore fixed income securities and how they work so that you can determine if they are the right investment strategy for your portfolio.

What is a fixed income security and how does it work?

A fixed income security is an investment that provides a return in the form of fixed periodic interest payments through coupon payments, while eventually investors regain the whole principal upon the security’s maturity. Unlike variable income securities, where payments change according to some underlying measure like, for instance, short-term interest rates, payments of fixed income securities are precisely as their name suggests – fixed and known in advance.

Typically, fixed income instruments are issued by governments, corporations and other entities in order to finance their operations. Some of the most common fixed interest securities include bonds, treasury bills, fixed income funds and others, all of which are considered low risk investments. As a result, they are often preferred by those who cannot take on too much risk.

So how do fixed income securities work?

Here is a real-life example:

If you consider bonds, these can have various maturities and face value amounts, in other words, the amount the investor will receive once the bond matures. Both corporate and government bonds trade on major exchanges and are usually listed with $1000 face values, also known as the par value.

Let us assume that a company issues a 5% bond available at a face value of $1,000 each and it is due to mature in five years’ time. If you invest $10,000 you will receive $500 in interest payments each year for the next five years. This equates to $2,500 interest over the five years. Once the bond matures, the company will repay you the principal – the initial $10,000 investment.

What are the advantages of fixed income investing?

A good strategy for those looking to achieve capital preservation, fixed income investments offer many benefits. Historically, they have provided higher returns that other types of investments like cash, while they are less volatile when compared to stocks. Here is an outline of some of the advantages:

• Capital preservation – essentially, capital preservation is making sure that the money you invest does not lose any of its value. Assets that have a clearly stated return amount and schedule carry less risks and therefore, are a good choice for investors who are more concerned of losing their principal investment because they do not have the time to recuperate any losses. Just bear in mind that the principal amount will be inaccessible during the term of your investment. However, it is important to point out that capital preservation will be realised if the business model of the underlying instrument has the ability to sustain the servicing of its debt. Fixed income securities that have an investment grade rating, tend to be less risky than those that are high yield rated and are therefore, more exposed to risk.
• Steady income – perhaps one of the most important benefits of fixed income is its ability to generate a reliable and steady source of income. Investors receive a fixed amount of income at regular intervals in the form of coupon payments on their holdings. When considering that interest rates are higher than most standard savings accounts, a fixed income investment is a good way of getting more value for your money.
• Low risk – the stable and steady interest payments from fixed income products can, to a certain extent, offset losses from the decline in stock prices and this can be particularly beneficial for investors who are closer to retirement and simply cannot risk their money. In addition, certain fixed income investments like government bonds have the backing of said government, while corporate bonds are backed by the financial viability of the company. Despite that, when a company declares bankruptcy or liquidation, bondholders tend to get a higher claim on a company’s assets than common shareholders, the level of recovery is very much dependent on the company’s asset base and ranking of the fixed income instrument. What conditions how low risk these securities are is the credit rating the company has received, as well as other considerations.
• Diversification – by allocating a portion of your portfolio to fixed income products, you are well on your way to diversifying your portfolio, while the wide variety of fixed income assets available means that you can further diversify your portfolio and mitigate any risks. Have a look at why having a diversified portfolio is important.

What are the disadvantages of fixed income investing?

Just like any other investment, there are some risks associated with fixed income investors should be aware of.

• Risk of inflation – due to the fixed amount of income that these securities offer, inflation risk can become a problem if prices rise by a faster rate than the interest rate on the security. So if a bond pays 2%, but inflation is rising by 4%, the investor is losing money when taking into account the rise in prices of goods in the economy and in this way, you lose purchasing power. Ideally, you should make sure that the fixed income security you have opted for pays a high enough interest rate so that the return beats out inflation. Despite high yield debt being riskier, in periods of rising inflation it is less sensitive when compared to investment grade bonds, as the higher coupon offers a cushion and mitigates inflation risk.
• Interest rates may rise – this is mainly tied to the risk of inflation. As inflation rises, central banks tend to increase interest rates to control the possibility of an overheating economy, which in term will impact the fixed income market.
• Risk of default – this can take place if you have invested in a fixed income security issued by a high-risk company which may be unable to repay your principal or interest. The same applies if you have invested in international bonds of a country that is economically or politically unstable.
• Liquidity risk – investing in a fixed income security means that the principal amount is tied up for a number of years. As a result, if you decide to cash in your investment earlier, there is a possibility of lost income, which is dependent on several factors. Nevertheless, it is important to point out that liquidity varies across the fixed income asset class. Government bonds tend to be highly liquid just as investment grade bonds, while the high yield fixed income market is less liquid.

What does investment grade mean?

Naturally, not all fixed income securities are made equal. So how do you decide where you should place your hard-earned money? Credit ratings provide a useful measure for comparing fixed income securities and they are given to issuers by credit-rating agencies such as the so-called Big Three – Standard & Poor’s (S&P) Global Ratings, Moody’s and Fitch Group. The rating that a security receives will depend on factors such as its financial viability and strengths, its prospects and past history. Typically, companies that have manageable levels of debt, good earnings potential and good debt-paying records will have good credit ratings, however, rating are not set in stone and they can change over time as the company’s strength and debt load changes.

In order for a security to be considered grade issue, it must receive a rating between the range of AAA and BBB from S&P or a range between Aaa to Baaa3 from Moody’s. Any security with a BB or lower rating is considered a junk grade, so the company’s probability to repay its issued debt is considered to be speculative.

What are the different types of fixed income products?

Treasury bills: short-term fixed income securities, treasury bills usually mature within one year and do not pay coupon returns or interest payments. Investors buy these at a price less than its face value and make a profit when the bill matures. This profit will ultimately be the difference. So for example, if a Treasury bill with a face value or par value of $100 sells for $90, then it is offering an interest of roughly 10%. Treasury bills are highly liquid, while they are considered a secure investment.

Government bonds: fixed income securities with diverse maturities, these bonds are issued by a government, usually are regarded as less risky, unless political or economic risks are in place. Having said that, since they tend to be the safest, they also offer the lowest return. Once the bond matures, the investor gets back what they initially paid together with any added interest along the way.

Understand the benefits of bonds and how they work.

Corporate bonds: issued by companies, the price and interest rate offered will depend on the company’s stability its creditworthiness and the current market conditions. Generally speaking, corporate long-term bonds tend to provide higher returns than government bonds, however, they carry more risk given that they can be conditioned by interest rate fluctuations and also specific risks surrounding the underlying business model. Technically bonds with higher credit ratings tend to pay lower coupon rates as they are deemed less risky.

High-yield bonds: these are corporate bonds with lower credit ratings, which means that companies pay a higher coupon due to a more complex capital structure which tends to me riskier. Issuers may be so-called rising stars, in other words, startup companies with high debt rations and so they are considered junk bonds but may be on their way to becoming investment quality. High-yield bonds could also be issued by former investment grade companies which have been reduced to junk bond status due to their poor underlying model which have ultimately reduced their credit quality. These are better known as falling angels, undermarked by a shift from a BBB to a BB rating.

Fixed income mutual funds: also known as bond funds, these are managed by a professional and they are essentially mutual funds that invest in various debt instruments, while they provide an income stream. With the potential to hold hundreds of bonds in a single fund, bond funds provide instant diversification for a low required minimum investment.

Fixed income ETFs: similar to mutual funds, these target specific credit ratings, durations or other factors and they offer exposure to a basket of fixed income securities. With the ability to target all corners of the market ranging from emerging market dept to first-rate government bonds, broadly speaking, fixed income ETFs fall into three main categories, namely:

• Sovereign – these target fixed income securities issued by governments of sovereign nations.
• Corporate – ETFs that target fixed income securities issued by corporations.
• Broad market – these have exposure to both sovereign and corporate debt.

Investing in fixed income with Calamatta Cuschieri

One of Malta’s largest independent financial services group and a founding member of the Malta Stock Exchange, Calamatta Cuschieri provides clients with access to virtually any fixed income security on the market, from bonds to bond funds and treasury bills. With the right expertise and resources, our experienced investment advisors can help you determine how fixed income fits into your portfolio, while they can identify the appropriate investments based on your financial goals and can also provide overall guidance. In addition, we also offer clients the possibility to monitor their investment portfolio online, as well as submit any bond orders through our CCTrader platform.

Here is the vast array of fixed income investments offered by Calamatta Cuschieri:

Individual Bonds

A highly convenient way of investing since you can calculate the precise stream of income you will receive, a fixed income bond ensures that you get regular income.

Bond Funds

Offering professional management, convenience, as well as diversification, mutual funds are an easy way to invest in fixed income.

Calamatta Cuschieri Bond Funds

Calamatta Cuschieri manages its very own High Income Bond funds, ideal if you are seeking to maximise return.

Other Fixed Income Investments

Additional fixed income products offered by Calamatta Cuschieri include capital guaranteed products which serve as an alternative option to building a balanced portfolio.

Treasury Bills

As an alternative to the low interest that savings accounts provide, you can also consider treasury bills for the cash allocation of your portfolio.

Why Calamatta Cuschieri?

• We have been investing in fixed income since 1972.
• We access the markets directly, making sure that you obtain the best possible prince in the market at any point in time.
• We offer dedicated fixed income research.

A popular choice among investors who hope to generate steady returns, fixed income investments can be an excellent alternative when considering that even the highest paying savings accounts are failing to keep pace with the cost of living. Armed with the necessary knowledge and expertise, CC’s financial advisors can review your situation and help you make the most of this investment strategy.

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