Fixed Income Securities & Economics
A main purpose of this essay is to convey information relevant to the exchange of a specific type of debt instrument. Factors under consideration herein center on gains that may accrue whether a holder buys, sells, or keeps the instrument. With respect to exchanges of debt, timing may be everything and certainly some times are better for some actions than are other times. One feature is the relationships between security price and other financial market variables including interest rates. This essay focuses its attention mostly on risk-free bonds, which the federal government buys and sells on a daily basis and in cycles. Open market operations, as a monetary policy tool, are used on a daily basis often influencing domestic and global economies. The essay approaches the topic from a broad perspective, but it may yield benefits for those readers who want consider adding fixed income securities to their investment portfolio.
Keywords Bond Issue; Bonds; Coupon; Coupon Rate; Debt Instrument; Denominations; Equity; Fixed Income Securities; Interest Rate; Loans; Maturity; Monetary Policy; Open Market Operations; Par Value; Present Value; Risk-Free Bonds; Security; Stocks; Time Value of Money; Yield
Economics: Fixed Income Securities
This essay condenses the basic concepts regarding fixed income securities and applies them in a manner that is relevant to the reader. The essay targets undergraduate college students as readers who may benefit from an initial condensed summary on a specific type of a fixed income security; namely those securities issued by the federal government of the United States. Persons around the globe hold a significant portion of those securities. While the essay ultimately approaches the topic from a broad domestic macroeconomic perspective, its contents may be instrumental in helping readers reap some financial gain from their own investment activities.
As a concise introduction to the topic, the government securities referred to herein are virtually default free and they pay holders a fixed amount of income in the form of interest payments. Readers should note, however, several varieties of securities are available through the financial market, which consist of individuals who exchange quantities of debt instruments at given interest rates. The interest rate and some other key requirements regarding the exchange of funds are expressed in a variety of ways. A private borrowing agreement governs loans whereas a public agreement governs bonds. Loan transactions usually involve a few individuals such as the lender, the borrower, and perhaps a co-signer.
Bond transactions however usually involve the public at large. Moreover, almost any bond sold is one from a set of bonds called a bond issue. The total amount of a bond issue may range in value from tens to hundreds of millions of dollars. An objective of a bond issuer is to borrow funds in large bundles from individual members of larger society. Bond issues may originate from corporations or local, state, or federal government agencies. A sequential process begins as bond issuers receive cash from each bond sold. Those who purchase a bond will receive interest payments on a regular basis until the date arrives at which the issuer returns cash to the buyer.
A security is a specialized form of bond. Nonetheless, readers will find them used interchangeably in the remainder of this essay. A house mortgage is one example of a bond secured through market value of the property and income of the borrower. While maintaining a clear distinction between loans and bonds, readers may find it convenient to think of a security as resembling a loan that has enough collateral to satisfy all the terms in an agreement. In brief, collateral effectively lessens the potential negative financial exposure faced by lenders or bond holders. Securities or bonds issued by the federal government are virtually a default-free and a risk-free loan given the expectation that the issuer will be fiscally solvent and perpetually functional beyond the foreseeable future and across a countless number of generations.
Stocks vs. Bonds
Another important distinction is appropriate at this point. It arises because references to stocks and bonds often give the appearance that they are interchangeable terms. Substantive distinctions exist between them though they share at least one common feature relevant to this essay. A stock involves taking equity or partial ownership in a company, which is exchanged on a daily basis in the stock market through sales and purchases. In contrast, as mentioned before, a bond resembles a loan. Typically, the bond holder owns only the debt it represents. On occasion, the issuer of corporate bonds will allow for their conversion into stocks, which means trading organization debt for organization equity or ownership. A far more common feature between stocks and bonds resides with the practice of purchasing them at the lowest price possible and then selling them at the highest price possible.
Generally, the expectation is that bonds act "primarily as a stabilizer" for portfolios; their role is to protect principal, "offer reasonable income with modest volatility, and serve as a diversifier of the more volatile equity allocation" (Co-published chapter: A different future for fixed income, 2013). Interestingly, between 2001 and 2011, a time during which "equities lost ground while bonds soared 9% a year" (Lim, 2011), "fear and greed worked together to send money pouring into bonds." Two-thirds of a trillion dollars flowed into bond mutual funds from the start of 2009 to the time of Lim's writing, in 2011, which represented more money than all stock funds attracted during the Internet bubble of 1998 to 2000 (Lim, 2011).
Fixed Income Securities
With the aforementioned distinctions and clarifications, we are now ready to examine fixed income securities in more detail. Fixed income securities contain three basic components according to Strumeyer (2005). This section describes those components and it provides a foundation for their application in a larger economic context.
- First is the coupon rate which specifies the security's interest payment.
- Second is maturity which specifies the security's term of investment.
- Last is the price or yield which specifies the security's market value.
The price of a bond generally reflects the time value of money, which means that a dollar today is worth more than a dollar tomorrow; conversely, a dollar received later is worth less than one in hand today. Furthermore, the present value of that dollar is likely to be less than its future value unless the loan period and the interest rate provide adequate compensation to the lender. Let us consider some additional terminology and basic mathematical calculations regarding bond pricing and exchanges.
Bonds are available in various denominations. An amount common to public issues of bonds is the $10,000 denomination. It represents the bond's face value, which by definition is the amount borrowed or the principal amount. In essence, individual members of the public can purchase the bond by providing $10,000 in cash to the bond issuer. By doing so, the issuer promises to return that sum of cash at a later point in time and to pay interest on that cash between now and then. Repayment of the $10,000 will occur on a specific date in the future, which by definition is the bond's maturity date. More precisely, payments of the principal amount and the last interest payment occur at maturity, but the bond holder receives interest payments every six months during that investment period. The amount of interest paid on an annual basis to the bond holder is by definition a form of fixed income.
Consider now what happens over time with the issuance and purchase of bonds. Let us begin by examining the hypothetical case of a bond bought on this date last year for $10,000. It promises to pay the purchaser or holder $1,000 per year in interest until maturity. By definition, the income payment on a bond is a coupon and the interest rate for a bond is its coupon rate. Exactly one year later, the issuance of another $10,000 bond contains an $800 coupon. In a basic sense, interest rates declined over the year from 10 percent ($1,000/$10,000) to 8 percent ($800/$10,000).
Next readers face the question: If the holder wants to sell the bond bought last year,...
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