A beginner’s guide to fixed interest investments
Are you interested in including fixed interest assets in your investment portfolio, but not sure where to start?
Fixed interest is one asset class that can help investors build their income streams, but it can be understandably overwhelming for new investors to take the first step. Here are the key features of the fixed interest asset class.
What is the fixed interest investment asset class?
Fixed interest investments aim to pay investors a fixed amount of income at pre-determined intervals up to a maturity date at which the initial borrowings on which the interest is calculated, is repaid.
Fixed interest investments may include debt securities, such as government and corporate bonds, debentures and capital notes, and they form a common component in many investment portfolios.
How do fixed interest investments work?
When companies and governments need to fund their day-to-day operations or larger projects, they often issue these fixed interest debt securities as a cost-effective and predictable way to raise this capital.
When investors purchase a fixed interest debt security, they are essentially providing a loan to these companies or governments.
In return, they are paid interest payments on the loan and are expecting their initial loan amount to be repaid at the maturity date. The interest payments are generally aligned with a benchmark rate, typically paying interest as a specified margin on top of the cash rate.
Understanding common fixed interest terms
While the concept of fixed interest is quite simple, its unique terminology can be challenging for new investors to understand. Here are 10 fixed interest terms you should understand.
1. Issuer
The entity, typically a company or government, that issues the debt security to raise money from investors.
2. Face or Par value
The initial stated value of the fixed interest debt security.
3. Coupon
The rate of interest paid on a fixed interest investment, expressed as an annual percentage of the bond’s face value. These are generally paid annually, semi-annually, quarterly, or monthly.
4. Maturity date
The legal date when the par value of the fixed interest security is due for repayment by the issuer.
5. Corporate debt
Debt issued by a corporation.
6. Sovereign debt
Debt issued by a government.
7. Supranational bond
Fixed interest debts that are issued by two or more central governments, together, to promote economic development for the countries involved.
8. Investment grade bonds
A bond with a credit rating, as determined by a credit ratings agency such as Standard and Poors (S&P), that is equal to or greater than BBB-. Different credit ratings agencies have different measurement systems as to how they rate the credit quality of the issuer.
9. Credit Rating
An estimate of the ability of the issuer to repay their debts owed, graded by independent ratings agencies such as Standard & Poor’s and Moody’s.
10. Default
Failure by the issuer to meet the terms of the loan.
Let’s put these terms into practice with an example fixed interest investment:
A government may issue a bond with a $1000 par value, 5% coupon rate, paid annually, for an investment term of 5 years. When an investor buys this bond, they will be paid a $50 coupon ($1000 x 5%) each year for five years by the issuer, earning a total of $250 in coupons over the investment term.
At the maturity date, the $1000 par value of the bond is repaid to the investor by the issuer, so the investor will have a total of $1250 at the end of the investment term.
Learn more fixed interest terminology.
Why do investors include fixed interest assets in their portfolios?
Fixed interest assets are included as part of a diversified portfolio for many reasons. Below are some key considerations when deciding if fixed interest is appropriate for your personal portfolio, financial goals, and risk tolerance.
1. Risk
Fixed interest has historically been regarded as a lower risk asset class compared to other asset classes, such as equities.
The credit rating assigned to the issuer by credit rating agencies will provide a good guide as to the financial risk associated with the issuer. For example, the Australian Government has a AAA credit rating (the highest credit rating achievable) which means the chance of the issuer defaulting on a payment is extremely low.
2. Income stream
As fixed interest is widely regarded as a less volatile asset class, it typically achieves lower, yet more predictable returns than other asset classes, such as equities, as the fixed interest instrument is designed to provide income payments of a predictable frequency. Fixed interest investments may constitute a predictable source of income for investors.
3. Portfolio diversification
Its reliability in providing a predictable income stream under the terms of offer makes fixed interest a popular option for portfolio diversification. Many investors include fixed interest in their portfolios to offset volatility and losses when equities or other assets in their portfolio are not performing.
Like all investments, there are risks associated with the potential returns and it is crucial to ensure the investment risk profile of your investment choice suits your personal circumstances. A licensed financial adviser can help you decide if this investment type is appropriate for you.
Investing in fixed interest in the current market conditions
While it’s possible for an individual investor to buy a single fixed interest security or manage multiple fixed interest investments themselves, volatile market conditions have created a challenging environment for investors seeking to invest in the fixed interest asset class, without professional advice, to generate a competitive risk-adjusted return.
Numerous fund managers offer fixed interest investment options that give investors access to professionally managed portfolios or single security products.
Investors who choose to invest in fixed interest assets this way can benefit from the fund manager’s experience, risk management approach and potentially access investment opportunities that are not available directly to you.
You should always ask for and read the offer document which outlines the way the product works and the risks involved, to ensure they meet your overall investment strategy and investment risk profile.
