Fixed Rate Bonds: Low Risk Investment Option or Danger in Disguise
Created on 24 Aug 2023
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Things in life are hardly fixed. Whether it is about the salary one may receive or the amount of rain a region can expect, this issue doesn’t have to be the case with your investments as well. If you are the type of investor who wishes to earn a prior set interest regularly, then fixed-rate bonds are the perfect option for you.
Fixed-rate bonds are a type of debt instrument that offers the same interest rate throughout their entire tenure. That’s why they are also called fixed-income securities. The interest payments one receives regularly from fixed-rate bonds are called coupon payments. After the maturing of the bond, the holder would receive their principal amount back in addition to the interest amount.
Government and corporate bodies issue fixed-rate bonds to investors seeking a fixed-rate of return, irrespective of market fluctuations. Mostly, the government issues fixed-rate bonds such as treasury notes, treasury bills, etc. It is also one of the reasons why government bonds are termed to be a low-risk investment option.
Fixed-rate bonds play a crucial role in diversifying an investment portfolio as they provide a stable return and help mitigate risk in current economic scenarios. So, let’s get on with the various features of fixed-rate bonds and how beneficial they are for an investor.
Features of Fixed-Rate Bonds
Fixed-rate bonds provide investors with a fixed advance payment stream. Along with this, some other features to take note of are:
Issuing authority: Fixed-rate bonds are generally offered by the Government of India. Recently, many other financial institutions have started offering these bonds as well.
Fixed Interest Rate: Fixed-rate bonds enjoy a fixed interest rate for their entire life. The rate is often described as a percentage of the bond’s face value.
Maturity: Fixed-rate bonds offer a maturity period, including short-term and long-term, ranging from 1 year to 5 years. An investor receives the principal amount back after the maturity period.
Interest Rate Risk: People often say that interest rate risks do not affect fixed-rate bonds. But reality has something different to say. Bond prices are inversely proportional to interest rate, which means the higher the interest rate, the lower the bond prices, and vice versa.
Tax implications: The interest received on bonds, i.e. the coupon payments, is taxed as per the Income Tax Act, 1961, at the applicable slab rates. However, there are some bonds issued by the government that are tax-free. Although, the capital gains received from the sale proceeds are still taxable.
Diversification: Fixed-rate bonds offer diversification to an investor’s portfolio. For investors who put money into risky equity investments for diversification, fixed-rate bonds would be a better prospect as they provide a guaranteed fixed interest rate.
Effect of Market Interest Rates on Bond Prices
Imagine a seesaw with one side holding prevailing interest rates in the market and the bond price on the other. Now, when one side goes up, say bond prices, then interest rates would decrease, and when interest rates go up, then bond prices would decrease. In short,
Higher market interest rates ➡️ lower fixed-rate bond prices
Lower market interest rates ➡️ higher fixed-rate bond prices
There are two ways to understand this effect on bond prices:
Rise of Interest Rate
Let’s say an investor purchases a bond that pays him a fixed interest rate of 6%. After a few days, the Reserve Bank of India announced some fiscal changes, and the interest rate went up to 8%.
This change in the interest rate made the bond less valuable because people would buy new bonds that offered them an 8% fixed interest rate. When an individual sells a bond before its maturity, they will be paid less due to the high interest rate applicable.
Fall of Interest Rates
Let’s assume another case where an investor bought a bond, offering him a fixed interest rate of 5%. The central government decides to reduce interest rates to curtail inflation. Thus, the prevailing market interest rate came down to 3%.
This change due to the government’s decision will impact the bond’s value positively in the bond market. When the investor sells the bond, they will be paid a higher value in exchange for the bond as the market is providing a lower interest rate.
Hence, we can conclude that bond prices are inversely proportional to market interest rates.
Advantages of Fixed-Rate Bonds
Investors with low-risk appetites prefer fixed-rate bonds for a variety of reasons. Some of those are stated below:
- Interest Rate
As the name suggests, fixed-rate bonds enjoy a consistent interest rate throughout their investment term.
Investors are sure about the exact interest amount (aka coupon payment) they will be receiving until its maturity. As the interest rate is already fixed, investors feel safe parking their money in fixed-rate bonds.
- Financial Planning
Investing in fixed-rate bonds helps an investor do well-thought and accurate financial planning that aligns with their investment.
Fixed-rate bonds are free from fluctuations that are usually a daily occurrence in the market. Unlike floating-rate savings bonds, they do not depend on market interest rates, thus providing traditional investors with better returns.
Disadvantages of Fixed-Rate Bonds
Despite providing numerous benefits to traditional investors, there are certain drawbacks to fixed-rate bonds that an investor must be aware of. Check out some of those below:
These fixed-rate bonds are not flexible as per market conditions. A long maturity period may erode the bond value in a market where the inflation rate increases every year.
- Lack of credibility
The Indian government used to issue bonds solely to fund its various projects. But now, almost every financial institution and private corporation has started offering these bonds. As a result, the bonds are losing credibility with the general public. The general public will not be able to get their money if these corporations go bankrupt.
- Interest Rate Risk
Fixed-rate bonds are subject to interest rate risk. There’s an inverse relationship between market interest rates and the price of bonds. As interest rates rise in the market, it leads to a decline in the value of bonds and vice versa.
The Bottom Line
The government and other financial institutions offer fixed-rate bonds to fund their various operations. Fixed-rate bonds are a great place for investors to pool their money because they generate a fixed-rate of return. These bonds help an investor do financial planning that aligns with the investment.
Fixed-rate bonds offer numerous advantages for investors who are looking for a secure and reliable source of income. However, these bonds are not free from disadvantages, as we discussed above.
Given all the pros and cons of these bonds, an investor needs to carefully analyze whether to add them to their portfolio or not. Apart from the maturity period, he must be aware of the right time to sell his bonds to protect the value of his investments.
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