 Personal Finance Powerpoint Presentation, Fixed Income Security, prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia Fixed Income Security, which you can find online. Take a look at the references, resources, continue your research from there. This is by Chris M. Murphy, updated August 31, 2020. And prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping them in mind. We're now asking, what is a fixed income security? A fixed income security is an investment that provides a return in the form of fixed periodic interest payments and the eventual return of principal at maturity. So typically, we're often thinking about bonds, for example, here, comparing and contrasting them, for example, to things like stocks or the equities, which typically do not have a fixed income that you will be receiving on the stock side of things. The bonds typically will have the general structure of bonds. You can think of it kind of like you're loaning money to someone in exchange for a promise, a note or a promise to return that money, for example, along with basically interest, which is like the earnings on the money, basically the rent of the use of the purchasing power of the money in a similar fashion as if you were to rent someone say an apartment building, you would expect the return of the property at the end of the rental and expect to have the earnings on it in the form of rent, which would be like the fixed kind of income per the agreement. Per the agreement here, the fixed kind of income typically being interest, which is basically for the purchasing power that has been given for an essence alone, for example, would be a general kind of example. So unlike variable income securities where payments change based on some underlying measure, such as short term interest rates, the payments of a fixed income security are known in advance. So that has benefits to it, of course, because now you have more assurity of what the payments will be, although you do not have the assurity of what the market is going to be doing. So whether or not that fixed amount of payments is going to be good or bad in the future will depend in part on what the market rates will be doing. Fixed income securities explained, fixed income securities are debt instruments that pay a fixed amount of interest in the form of coupon payments to investors. So typically a coupon payment is kind of like the interest payment calculation generally. The interest payments are typically made semi annually, while the principal invested returns to the investor at maturity. So you're kind of like loan and money. You're going to get basically periodic payments, which are typically going to be the interest payments and then possibly get the return of the principal, the loan at the end. Bonds are the most common form of fixed income security. So typically when you hear fixed income security, it's not exactly synonymous with bonds, but that's the first thing that should be coming to mind. So companies raise capital by issuing fixed income products to investors. So when you think of bonds, you might say, well, who's going to give the bonds? Who's issuing the bonds? Possibly the government, possibly companies. So then you could think about different kinds of bonds and the security of the person that's issuing the bonds in terms of how secure are they that they'll be able to repay the bonds, just like you would if you were to loan money to an individual. For example, what's the likelihood that this guy is going to give me the money back? What's the likelihood that the government's going to give me the money back versus a company versus a different company? For example, a bond is an investment product that is issued by corporations and governments to raise funds to finance projects and fund operations. So obviously they want the money, the cash flow to expand operations on the government side that just put on a bonfire and let it burn. Now they use it for whatever they do. And on the company side, they're hopefully growing the company with the cash flow. So bonds are mostly comprised of corporate bonds and government bonds and have various maturities and face value amounts. The face value is the amount the investor will receive when the bond matures. So the face amount is the amount that you're going to get back when the bond returns in essence, generally kind of like you could think of it as the return in essence of the principle. Corporate and government bonds trade at major exchanges and usually are listed with $1,000 face value. So when you think about valuing the bonds, you might buy multiple bonds. You could think about them oftentimes as $1,000 increments. So also known as the power value. So credit rating fixed income securities. Now all bonds are created equal, meaning they have different credit ratings assigned to them based on the financial viability of the issuer. So if you're going to loan someone money, for example, that's going to be paying you interest just like the bank does with you when you want to mortgage or something, you got to say, what is this person credit worthy? What's the likelihood that they're going to default if they go bankrupt? I'm not going to get my money. So how likely am I going to get my money? So credit ratings are part of the grading system performed by credit rating agencies. These agencies may share the credit worthiness of corporate and government bonds and the entity's ability to repay these loans. Credit ratings are helpful to investors since they indicate the risks involved in investing. Bonds can either be investment grade or non-investment grade bonds. Investment grade bonds are issued by stable companies with a low risk of default and therefore have lower interest rates than non-investment grade bonds. So typically for the average investor, when you want exposure to bonds, you're typically looking for more security as opposed to, say, the stocks. And oftentimes you're looking for the more secure type of bonds. And then when people are getting more into bonds, then they might look at more kind of riskier bonds in those cases, but again, a general investor oftentimes looking at more secure types of bonds. So large company bonds and government bonds. Non-investment grade bonds, also known as junk bonds or high yield bonds. So now you're looking at bonds that are more risky, but oftentimes with that risk, they might have to give a higher return. Because if you think about it clearly, if you've got the market conditions, if I was to be able to get a loan or loan money too and get a return from loaning money to the government or loaning money to a large company, which is not likely to go bankrupt versus loaning money to a small company, which has a much higher likelihood of going bankrupt, then that smaller company is going to have to give me a higher return, just given market conditions in order for me to invest in them as opposed to giving my money for a more secure return. So they have very low credit ratings due to high probability of the corporate issuer defaulting on its interest payments. As a result, investors typically require a higher rate of return from junk bonds to compensate them for taking on the higher risk posed by these debt securities. So types of fixed income securities. Although there are many types of fixed income securities, below we've outlined a few of the most popular in addition to corporate bonds. So we've got the treasury notes. We've talked a lot about these in prior presentation, so I won't spend a lot of time on them, each of them. But you've got the T-notes are issued by the US Treasury on our intermediate term bonds that mature in two, three, five, or ten years. T-notes usually have a face value of $1,000 and pay similar annual interest payments at fixed coupon rates or interest rates. The interest payments and principal payments of all treasuries are backed by the full faith and credit of US government, which issues the bonds to fund its debt. So that's usually our baseline to think about bonds. The ones issued by the federal government because they're usually thought to be basically kind of risk-free because they got the good old printing press over there and they can always raise taxes. So you would think if they were to default, things would be quite bad. So hopefully those are pretty much risk-free. Another type of fixed income security from the US Treasury is the Treasury bond, T-bond, which matures in 30 years. Treasury bonds typically have par values of $10,000 and are sold on auction on Treasury Direct. Short-term fixed income securities include Treasury bills. The T-bills mature within one year from issuance and don't pay interest. Instead, investors buy the security at a lower price than its face value or a discount. So they're basically bonds but structured a little bit differently because they're not going to be giving the semi-annual payments because they're very short-term in nature, but rather the interest is kind of built in to the fact that you're going to buy the item, the T-bill for less than the face amount, and then they're going to pay you the face amount at the end of the term, which is basically the interest. So the bill matures, investors are paid the face value of the amount. The interest earned or return on the investment is the difference between the purchase price and the face value amount of the bill. So a municipal bond is a government bond issued by states, cities, and counties to fund capital projects such as buildings, roads, schools, and hospitals to the interest earned from these bonds is tax exempt from federal income taxes. So it's kind of interesting the way it all plays out that the ones that are issued on the municipal side are the ones that could be tax exempt on the federal side. You would think that the federal bonds would be the ones who would be tax exempt possibly on the federal side, but the idea there is basically that the states should be able to earn revenue of the original idea or do their own thing without the Fed kind of influencing. And so that's how that kind of developed. But in any case, also the interest earned on a muni bond might be exempt from state and local taxes if the investor resides in the state where the bond is issued. The muni bond has several maturity dates in which a portion of the principal comes due on a separate date until the entire principal is repaid. Munis are usually sold with a $5,000 face value. So a bank issues a certificate of deposit, a CD. So this is another kind of fixed type of investment kind of similar to a savings account. But when you go to the bank and say, hey, look, I'm going to give you the money, lock it down in a CD. I'm not going to take it out. If I do, you can penalize me. That's going to be good for the bank because what the bank does, you might ask, like, how does the bank even make money? Like I just have a checking account there and they do everything and they charge me very little for it. Well, that's because they're not holding on to all the money that you have in the checking account. They're actually investing it only holding on to enough to repay as needed when you draw the money out. So if you tell them that you're not going to draw the money out, put it under a CD, then they can invest your money more easily without having to worry about you pulling it out earlier and they can make a higher return. So you get a return on the CD. So in return for depositing money with the bank for a predetermined period, the bank pays interest to the account holder. CDs have maturities of less than five years and typically pay lower rates than bonds, but higher rates than traditional savings accounts. So you're going to say, well, bonds might give a higher return. You're often comparing, say, bonds to, like, a CD, the CDs, because you're locking them in and you can't pull the money out without being penalized, generally, are generally going to give a higher return than, say, a savings account. A CD has the Federal Deposit Insurance Corporation, FDIC insurance, up to $250,000 per account holder. That's a big advantage because that came about when they were worried about the bank runs because if you think about how this, what we just said, the bank basically is taking your money and investing it. Well, what if everybody asked for their money back? The bank wouldn't have it because it's invested. So then if panic starts, there would be a bank run. To stop the bank run, the Fed basically said, we're going to insure the bank by this $250,000, which gives you another safety net in the event that the whole bank goes bankrupt, for example. So in order to get the most out of this kind of security, be sure to do your research to determine what CDs offer the best rates currently available. Companies issue preferred stocks that provide investors with a fixed dividend, set a dollar amount or percentage of shares value on the predetermined schedule. Interest rates and inflation influence the price of preferred shares, and these shares have higher yields than most bonds due to their longer duration. So benefits of fixed income securities. Fixed income securities provide steady interest income to investors throughout the life of the bond. So if you have a fixed income for it, you're basically investing and you're getting the income from it. That could be good, especially in retirement years, for example, if you're kind of wanting that fixed income to basically be living on. So for example, fixed income securities can also reduce the overall risk in an investment portfolio and protect against volatility or wild fluctuations in the market. So even if you're not reliant on the fixed income, you still might want to put it into the fixed income or have a portion oftentimes breaking out between, say, stock, bonds, CDs, and so on so that you're not fully just exposed to equities because if the market declines, then the equities can go down drastically and you could have a hedge by having the fixed income, which hopefully is going to hedge against the volatility possibly. So equities are traditionally more volatile than bonds, meaning their price movement can lead to bigger capital gains but also larger losses. As a result, many investors allocate a portion of their portfolio to bonds to reduce the risk of volatility that comes from stocks. This is something every investor, most investors, advise, but something that many investors themselves have trouble actually doing because in good times, it's hard to put a lot of your money into bonds because you're not seeing a return on it and you're going like, why, I can't, you know, but when things are down and when things are down, then oftentimes you get hit so hard, many people get so hard hit by a recession or something, that then they take all of their money and they put it into bonds or a CD and stuff and then they lose their balancing of the portfolio in that way. So this whole idea of diversity, investing in bonds is easy to say, often hard for investors to do in practice because we get emotional as the market goes ups and downs. So it's important to note that the prices of bonds and fixed income securities can decrease and decrease as well. Although investment payments of fixed income securities are steady, their prices are not guaranteed to remain stable throughout the life of the bond. So for example, if investors sell their securities before maturity, there could be gains or losses due to the difference between the purchase price and the sales price. So when you invest in bonds and also note that you might kind of try to get exposure to bonds by buying something like mutual funds and that kind of thing. And again, if you buy and sell the funds or you buy and sell the bonds, then you could be subject to capital gains on it and just like you would otherwise. In other words, when you hold on to the bonds, the interest income that you're receiving is gonna be that fixed kind of income that you'd be receiving, but you can also take the bond and sell it on the secondary market, the primary market being you buy it from the bond issuer, the government or the corporation typically, the secondary market being you now sell it to another investor, two investors are selling it and you might then have a capital gain if you sell it for more than you purchase for, could have tax implications there. So the investors receive the face value of the bond if it's held to maturity, but if it's sold beforehand, the seller price will likely be different from the face value. So note that the ability to sell the bonds on the market also makes them more liquid. So you might say it's a 20 year bond, but you can basically sell it, so you could kind of get access to it if you need the cash. That's a little bit different, for example, than say a CD, which you can't really tap into without basically being penalized under the terms of the CD, for example. However, fixed income securities typically offer more stability for principle than other investments. Corporate bonds are more likely than other corporate investments to be repaid if a company declares bankruptcy. So if the company, like you invest in the company and the company goes bankrupt, well, that's not good because then they might not be able to pay things off, but the bondholders typically hire in line on who gets paid first, then say the stockholder. So you're actually in a better position to possibly getting paid there unless the government comes in and says they're too big to fail and they mess everything up according to some crazy whatever, changing up all the rules or whatever. But for example, if a company is facing bankruptcy and must liquidate its asset, bondholders will be repaid before common shareholders. So the U.S. Treasury guarantees government fixed income securities and considers safe haven investments in times of economic uncertainty. So on the other hand, corporate bonds are backed by the financial viability of the company. In short, corporate bonds have a higher risk of default than government bonds. So clearly government, because they have a printing press and the power to tax, you would think would be the least risky place to be put in your money to invest in bonds. Large corporations, because they're large corporations, you would think would be the next kind of stable place to go. But then of course, you're not gonna get as higher returns as they're more stable because you have a more guarantee of return and the market then will require less of a return in order to invest in them. Typically the more risk you take on, the market is gonna demand higher returns. So default is the failure of the debt issuer to make good on their interest payments and principal payments to investors and bondholders. So just like if you default on your mortgage, if they default paying the interest to you and the principal, they're defaulting. Contract, broken, problem happened. So fixed income securities are easily traded through a broker and are also available in mutual funds and exchange traded funds. So many basically common investors that are investing in for like retirement and an IRA 401K or something like that may try to get exposure, often try to get exposure or get exposure using something like mutual funds, for example, mutual funds and ETFs contain a blend of many securities in their funds so that investors can buy into many types of bonds or equities. So pros, fixed income securities provide steady interest income to investors throughout the life of the bond. Fixed income securities are rated by credit rating agencies allowing investors to choose bonds from financially stable issuers. And that's great, by the way, but just note that sometimes these crediting agencies have not always predicted when someone's gonna default. So you can't say that they're like full proof. So whenever they say like government bonds, for example, are risk-free, totally risk-free really. I mean, I don't think there's such a thing as that but clearly the rating agencies are a good tool. So all those stock prices can fluctuate widely over time, fixed income securities usually have less price volatility. Fixed income securities, such as US Treasuries, are guaranteed by the government providing a safe return for investors. On the con side of things, fixed income securities have credit risk meaning the issuer can default on making the interest payments or paying back the principal. Fixed income securities typically pay a lower rate of return than other investments such as equities, they're not as interesting that way. Inflation risk can be an issue if prices rise by a faster rate than the interest rate on the fixed income security. So if you basically locked into a fixed income security, you've got that rate risk in that you're getting a guaranteed return, but if the market goes up, like inflation goes up, market rates go up, then that guaranteed return that you have doesn't look as good because if you had the money, you could then possibly invest in other areas and get a greater return. But if the market rate kind of goes down, then your investment looks good because you fixed in the rates kind of similar but opposite to fixing the mortgage rate and the market rates changing, for example. So if interest rates rise at a faster rate than the rate on a fixed income security, investors lose out by holding the lower yield security. Risk of fixed income securities. Although there are many benefits to fixed income securities and are often considered safe and stable investments, there are some risks associated with them. Investors must weigh the pros and cons of before investing in fixed income securities. Investing in fixed income securities usually results in low returns and slow capital appreciation or price increases. So they're not jumping up like a stock. It's not like you invested, you just luckily invested in Apple when it jumped up to the moon or something like that's not gonna happen, but you get a steady return. The principal amount invested can be tied up for a long time, particularly in the case of long-term bonds with maturity is greater than 10 years. As a result, investors don't have access to the cash and may take a loss if they need the money and cash in their bonds early. Also, since fixed income products can often pay a lower return than equities, there's the opportunity of lost income. So you may not earn as much as you might in equities, but that's kind of the price you pay if you're trying to balance the portfolio, for example, that's the pros and cons that go along with that. You can't release, if you have a long-term maturity, you may not be able to sell the individual bond as easily although you might be able to sell it on the secondary market accessing possibly cash flow. And that way, if it's under the umbrella of an IRA or a 401K plan, then again, it's more restricted because that's why it's under that umbrella, as opposed to if it was outside that umbrella, you might be able to sell it on the secondary market. Fixed income securities have interest rate risk, meaning the rate paid by the security could be lower than interest rates in the overall market. For example, an investor that purchases a bond paying 2% per year might lose out if interest rates rise over the years to 4%. Fixed income securities provide a fixed interest payment regardless of where interest rates move during the life of the bond. If rates rise, existing bond holders might lose out on the higher rates. Bonds issued by a high-risk company may not be repaid resulting in loss of principal and interest. All bonds have credit risk or default risk associated with them since the securities are tied to the issuer's financial viability. If the company or government struggles financially, investors are at risk of default on the security. Investing in international bonds can increase the risk of default if the country is economically or politically unstable. Inflation erodes the return on fixed income bonds. Inflation is an overall measure of rising prices in the economy. Since the interest rate paid on most bonds is fixed for the life of the bond, inflation risk can be an issue if prices rise by a faster rate than the interest rate on the bond. If a bond pays 2% and inflation is rising by 4%, the bond holder is losing money when factoring in the rise in prices of goods in the economy. So if that happens, then you could then look at the equities and compare to the equities. The fact that you're losing out still might not be the worst thing if, for example, you also are in a situation where equities are going down because on the equity side of things, you can actually lose money on the equities. Where on the bonds, you're gonna be losing money due to the purchasing power of the dollar going down, but the losses might not be as extreme as if you're in a recession with the stock prices actually going down. So in any case, ideally investors want fixed income security that pays a high enough interest rate that the return beats inflation. So clearly you would like to have earnings greater than the decline in the purchasing power of the dollar, the inflation. So real-world example of fixed income securities. As I mentioned earlier, treasury bonds and long-term bonds with a maturity of 30 years. T-bills provide semi-annual interest payments and usually have $1,000 face values. The 30-year treasury bond that was issued March 15th, 2019 paid a rate of 3%. In other words, investors would be paid 3% or $30 on their $1,000 investment each year. The $1,000 principle would be paid back in 30 years. On the other hand, the 10-year treasury note that was issued March 15th, 2019 paid a rate of 2.625%. The bond also pays semi-annual interest payments at fixed coupon rates and usually has a $1,000 face value. Each bond would pay $26.25 per year until maturity. We can see that the shorter term bond pays a lower rate than the long-term because investors demand a higher rate if their money is gonna be tied up longer and longer-term fixed income securities.