Meaning of Fixed-income Securities
Fixed-income securities are particularly popular with conservative investors. Some of them can be traded on the stock exchange in the form of bonds or convertible bonds. As savings bonds, they have the legal form of a registered bond, which cannot be resold. Fixed-income securities represent a form of borrowing by the issuer. Similar to a loan, the term is fixed, as is the interest rate for the duration. In theory, this means that there are no risks for the investor with regard to the repayment. In contrast, shares are a matter of raising equity: the shareholder is a partner in the company.
- Bonds are usually issued in nominal terms in denominations of 1,000 units of a currency.
- In the case of fixed-income securities that are traded on the stock exchange, there is a difference between the contractually stipulated nominal interest rate and the yield.
- The market knows different types of fixed-income securities: classic bonds, SME bonds, Pfandbriefe, savings bonds and convertible bonds.
By issuing a bond, the issuer, the debtor, takes out a loan on the capital market. Bonds are usually issued in nominal terms in denominations of 1,000 units of a currency. Depending on the market situation, the first issue will also take place with a slight premium or discount on the face value. The value is given in percent. According to abbreviationfinder, the term of a fixed-income security is set in advance, as is the interest rate.
Determining the rate of return
In the case of fixed-income securities that are traded on the stock exchange, there is a difference between the contractually stipulated nominal interest rate and the yield. Here is an example: The nominal interest rate is three percent, the paper has a remaining term of two years and the price at which it was purchased on the stock exchange was 98 percent. The investor receives two more three percent interest on the nominal value before the due date. If this is 1,000 euros, the interest credit amounts to 30 euros per year. The bond will be redeemed with 100 percent at the end of the term, the investor receives a credit of 100 percent, 1,000 euros. Since he only paid 98 percent, 980 euros, his price gain amounts to a further 20 euros. Spread over the holding period of two years, this means 10 euros per year, ergo an annual profit of 40 euros. So the actual return was four percent per year. If the purchase price was over 100 percent, the return falls accordingly below the nominal interest rate.
The market has different characteristics for fixed-income securities. The best known is the bond. Bonds are issued by states, municipalities or companies. The interest rate on a bond depends on the creditworthiness of the issuer. It is therefore important for investors not only to focus on the return. The higher the interest rate, the greater the risk that the bond will not be repaid as required. Argentina in the 1990s and the Greek crisis are evidence that government bonds can also go bad. When selecting an issuer, the rating provides information on how good the issuer’s creditworthiness is.
In the recent past, more and more medium-sized companies have offered the direct purchase of bonds with interest rates that are unusual for the market. However, these should be viewed critically, as it is questionable why the house banks refrain from financing. This would be much less complicated than issuing a security. Investor advocates assign these bonds to the gray capital market.
In terms of security, Pfandbriefe have a special position with fixed-income securities. These securities are issued by Pfandbrief companies and are used to refinance the mortgage business. The security for the Pfandbriefe is provided by the borrower’s property on which they are lent. However, since these are only lent with 60 percent of the actual value, the security buffer is enormous. In the history of the German Pfandbriefanstalt there has never been a default. Like bonds, Pfandbriefe are traded on the stock exchange.
Savings bonds fall under the term fixed-income securities in the broadest sense. They cannot be traded on the stock exchange, but are booked into the customer’s securities account. They are also used by credit institutions for refinancing, but in terms of security they are covered by deposit protection. The features are the same as those of a bond, but early return is not possible. In this context, they have the character of a fixed-term deposit.
Convertible bonds represent a special variant of fixed-income securities. In terms of issuance and features, it is a classic bond up to the due date. Only at the end of the term do they deviate from a bond. The issuer, a stock corporation, can now decide whether the investor will receive the nominal amount back or whether it will be paid out in shares of the company instead. This combination combines borrowing with equity raising.