What Is a Fixed-Interest Security?
A fixed-interest security is a debt instrument such as a bond, debenture, or gilt-edged bond that investors use to loan money to a company in exchange for interest payments. A fixed-interest security pays a specified rate of interest that does not change over the life of the instrument. The face value is returned when the security matures.
In the U.K., fixed-interest securities are referred to as "gilts" or gilt-edged securities.
How a Fixed-Interest Security Works
The fixed interest to be paid on a fixed-interest security is indicated in the trust indenture at the time of issuance and is payable on specific dates until the bond matures. The benefit of owning a fixed-interest security is that investors know with certainty how much interest they will earn for the duration of the bond's life.
As long as the issuing entity does not default, the investor can predict exactly what their return on investment will be. However, fixed-interest securities are also subject to interest rate risk. Since their interest rate is fixed, these securities will become less valuable as rates go up in a rising-interest-rate environment. If interest rates fall, however, the fixed-interest security becomes more valuable.
For example, let’s assume an investor purchases a bond security that pays a fixed rate of 5%, but interest rates in the economy increase to 7%. This means that new bonds are being issued at 7%, and the investor is no longer earning the best return on their investment as possible.
Because there is an inverse relationship between bond prices and interest rates, the value of the investor’s bond will fall to reflect the higher interest rate in the market. If they decide to sell their 5% bond in order to reinvest the proceeds in the new 7% bonds, they may do so at a loss, since the bond’s market value would have dropped. The longer the fixed-rate bond’s term, the greater the risk that interest rates might rise and make the bond less valuable.
If interest rates decrease to 3%, however, the investor’s 5% bond would become more valuable if he were to sell it, since a bond’s market price increases when interest rates decrease. The fixed rate on their existing bond in a declining-interest-rate environment will be a more attractive investment than new bonds issued at 3%.
Weighing the Risks
Fixed-interest securities are less risky than equities, since in the event that a company is liquidated, bondholders are repaid before shareholders. However, bondholders are considered unsecured creditors and may not get any or all of their principal back given that they are next in line to secured creditors.
Risk-averse investors seeking a stable source of income payments at predictable intervals typically opt for fixed-interest securities. Examples of fixed-interest securities include government bonds, corporate bonds, step-up securities, and term deposits, etc.
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