Finance of Fixed Income Securities
This article focuses on the relative advantages and disadvantages of fixed income securities, which are investments that provide a predictable rate of return over a specified period. As is discussed, fixed income securities include various types of government and corporate bonds, savings accounts, certificates of deposit, and preferred stocks. Fixed income securities are usually evaluated in terms of factors such as level of risk, rate of return, and the special features different types of securities offer. In general, fixed income securities are considered an important part of investment portfolios.
Keywords Agency Security; Annual Percentage Rate; Bond; Bond Fund; Bond Laddering; Callable Bonds; Certificate of Deposit; Compounded Interest; Corporate Bond; Debenture Bond; Fixed Income; Fixed Income Security; Interest; Investment Risk; Liquidity; Maturity; Municipal Bonds; Preferred Stocks; Principal; Savings Account; Security; Simple Interest; T-Bill; Treasury Inflation-Protected Securities (TIPS); Treasury Security; Volatility; Zero Coupon Bonds
Finance: The Finance of Fixed Income Securities
The money you earn comes from essentially two sources: salary from your job, and income from your investments. While a salary is almost always the same amount from month to month, how much money you earn from investments can vary, or, like a salary, it can be the same amount. In the latter scenario, your income is fixed-that is, the amount you earn doesn't change; you know what to expect each month. Investment earnings that stays the same on a regular basis are referred to as fixed income, and often come from investment securities-tradable instruments such as stocks and bonds that reflect an investor's ownership in, or debt obligations from, a company or government agency ("Definitions," 2007). Many investors prefer at least a part of their investment portfolios to be fixed because they can count on a certain amount of their income to be predictable and steady.
Fixed income securities-those investments which produce the same amount of money on a regular basis-have several advantages besides producing steady income. They often give conservative investors piece of mind, because, unlike stocks, their performance is characterized by low volatility. They also help diversify a portfolio by offering a steady, stable stream of revenue. Finally, many forms of fixed income securities provide tax advantages; in the case of many bonds, income from some sources may be exempt from Federal, state, and local taxes.
There are also disadvantages to holding fixed income securities (Fidelity Investments, 2007). For example, they may react negatively to an increase of interest rates, represent a credit risk if the company or agency has financial problems, or lose their value because of inflation over a long period of time. They may also be "called in" or redeemed early, if the issuer pays off its debt early, in which case the investor would not receive the expected amount of earnings. Finally, especially in the case of long-term investments in which money is obligated for many years, other more advantageous investment opportunities may be by-passed, which is referred to as reinvestment risk. Astute investors therefore must balance the pros and cons of fixed income securities as they clarify their investment goals and build their portfolios.
Types of Fixed-Income Securities
One of the most common types of fixed-income securities is a bond, or loan one entity makes to another. Bonds commonly offer fixed income in the form of Treasury Securities, Agency Securities, Corporate Bonds, and Municipal Bonds (U.S. Department of the Treasury, 2007).
Treasury securities are debt obligations issued by the U.S. Government. They are backed in "full faith" by the government, which means they are virtually risk-free (Fidelity Investments, 2007). A treasury security is a type of bond, or loan, made to the government, and earns interest over its period of ownership, which is usually several years. At the end of the specified period, the bond reaches maturity-the date at which the principal (the amount invested) is returned to the buyer. Treasury securities are known for their safety, tax advantages, and liquidity. Their downside is that they generally have lower rates of return than other types of more assertive investments. Savings bonds are also forms of treasury securities, as are T-Bills which are short-term government obligations.
Agency securities are also relatively low-risk obligations that are issued by "agencies" or enterprises that the U.S. government supports. They are not fully backed by the government and are taxed differently. Because they are technically considered a greater risk than treasury securities, they typically earn higher interest. Examples of agency securities include mortgage-based investments sponsored by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac).
Municipal Bonds (called "munis") are securities issued by local governments such as states or cities. Munis are typically exempt from Federal, state, and local taxes and are issued in denominations of $5,000. They are usually created to help fund public projects, such as new highways, school facilities, or hospitals (Securities and Exchange Commission, 2007). Depending on their purpose, the terms of these bonds can vary from several months to as long as 30 years. Munis are generally low-risk and low-yield but contribute an important aspect to an investor's portfolio.
Corporate bonds work like municipal bonds, but the issuer is a private company rather than an agency of government. Unlike munis, which are usually offered over-the-counter in denominations of $5,000, corporate bonds are sold through exchanges and are sold in denominations of $1,000. Because they are not backed by the government like municipal bonds and treasury bonds, they are considered riskier and therefore produce a higher rate of return. They are also not backed by any agency of the U.S. government.
Other Types of Fixed-Income Securities
Although bonds, in their various forms, represent a major type of fixed-income security, there are other instruments that provide a steady, predictable stream of revenue. These include savings accounts, certificates of deposits, and preferred stocks.
The most basic type of investment, a savings account is essentially a loan a depositor makes to a financial institution. If the institution is insured by the Federal Deposit Insurance Commission (FDIC), the deposit is guaranteed safe by the government up to $100,000. Therefore, it is a considered a safe type of investment. However, while savings accounts provide regular income-usually credited to a depositor's account once a month based on an annual...
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