Guest Post by Vrushank Setty
What is a Fixed Income (FI) instrument?
A fixed-income instrument is an investment tool where the investors get a stable or a measurable form of return for their investments. We are using the term “measurable” because the return payments are known well in advance. These returns are in the form of periodic interest payments and eventual repayment of principal at maturity of the instrument.
For example: let’s consider a bond (A very common form of fixed income instrument) that pays 3% coupon for 3 years and pays a principal of 1000$ at the end of 3rd year.
Payoff for this bond would look like:
Interest Rate calculation:
Year 1: 1000*3%
Year 2: 1000*3%
Year 3: 1 000*3%+1000
The pricing of Fixed Income instruments will be covered in depth in a future article.
Different types of fixed income (FI) Instruments
There are various types of fixed income instruments issued by entities such as banks, multinational corporations and other government entities, either to finance their operations or to fund various governmental projects like dams, national highways etc.
Different types of FI instruments are:
- Corporate Bonds
- Certificate of deposits (CD)
- Treasury Bonds
- Guaranteed investment certificates (GICs)
- Mortgage back securities (MBS)
What are Bonds?
Bonds are the most common form of fixed income instruments in the market. A bond is basically a contract made amidst an investor and a borrower. Wherein the borrower (usually a corporation or a sovereign) promises to pay a fixed return (in form of coupon payments) and return back the principal amount at maturity.
Types of Bonds
Based on the needs of the issuer, there are different types of bonds available in the market. The most common types are given below:
(I) Treasury Bonds: Also known as T-bonds are government debt securities issued by the federal government with maturities ranging between 10-30 years. T-bonds are considered to be risk-free bonds since they are backed by the government and are also used as a benchmark with other types of bonds
(II) Investment Grade Corporate Bonds: These bonds are issued by corporations and have a relatively low risk of default (i.e. failure to make a coupon payment/ return principle) compared to High Yield corporate bonds. These bonds have high credit ratings attached to them by credit rating agencies like Standard and Poor’s, Moody’s, etc. Since these bonds have relatively high credit ratings, the risk premium expected is low and consequently they have lower yields.
(III) High Yield Corporate Bonds: These bonds are issued by corporations and have a relatively higher risk of default as compared to Investment Grade Bond. These bonds have a lower credit rating attached to them and consequently have a higher yield (greater risk premium).
(IV) Foreign Bonds: It is a bond issued in a domestic market by a foreign entity in the domestic market’s currency as a means of raising capital. Example: Samurai bond is a yen-denominated bond, issued in Tokyo by a non-Japanese company and is subject to rules and regulations of the Japanese government.
(V) Municipal Bonds: It is a debt security issued by a municipality, state or county to finance it’s capital expenditures such as the construction of national highways, bridges, dams etc. These bonds do enjoy exemption from federal tax.