Which Factors Most Influence Fixed-Income Securities?

What Are Fixed-Income Securities?

Fixed-income securities are debt instruments issued by governments, corporations, and other entities to finance their business activities.

A buyer of fixed-income securities in effect loans money to the issuer. In return for this loan, the issuer of the security agrees to pay a fixed amount of interest on a regular schedule until the security’s maturity date. Upon maturity, the borrower returns the principal loan amount to the investor.

There are several different type of fixed-income securities, including U.S. Treasuries, corporate bonds, high-yield bonds, tax-free municipal bonds, and certificates of deposit (CDs).

The main factors that impact the prices of fixed-income securities include interest rate changes, default or credit risk, and secondary market liquidity risk. Read on to learn more about each of these.

Key Takeaways

• Fixed-income securities are debt instruments issued by governments, corporations, and other entities.
• Investors in fixed-income securities are loaning money to the issuers in return for a fixed amount of income plus the return of the amount loaned.
• Factors that most influence the prices of fixed-income securities are changes in interest rates, the risk that an issuer may default on their payment, and lack of liquidity in the secondary market.
• Fixed-income investors also face the risk that inflation will erode the value of income they earn.
• Types of fixed-rate securities include Treasury bonds, corporate bonds, municipal bonds, and CDs.

Factors That Most Influence Fixed-Income Securities

Changes in Interest Rates

The main risk that can impact the price of bonds is a change in the prevailing interest rate. The price of a bond is inversely related to the direction of interest rates.

As interest rates rise, bond prices fall. This is because investors can obtain bonds with a superior interest rate, which decreases the value of a bond that has already been issued.

On the flip side, existing bond holders benefit from a drop in interest rates, as it makes their investments more valuable to other investors seeking the higher yields of previously issued bonds.

Importantly, bonds with longer maturities are subject to greater price movement when interest rates change. That’s because an interest rate change has a larger impact on the future value of the coupon.

Note

Components of a fixed income security include the rate for the fixed amount of interest, which is known as the coupon rate and the principal amount of the bond, known as the security’s par or face value.

Credit or Default Risk

The second factor is credit or default risk. There is always a risk that an issuer will go out of business and be unable to make interest payments or meet its principal repayment obligation.

Issuers of high-yield bonds (also known as junk bonds) present more credit risk since there is likely to be a greater risk of default. To compensate investors for this higher risk, such bonds often pay higher interest rates.

Rating agencies provide credit ratings for the issuers of bonds and can help investors gauge the risk associated with certain corporate bonds.

Liquidity Risk

Except for government debt, most bonds are traded over the counter (OTC) and therefore carry a liquidity risk.

Unlike the stock market, where usually investors can easily exit a position, bond investors rely on the secondary market to trade bonds. Investors who need to exit a bond position to regain access to their invested principal may have a limited secondary market in which to sell the bond.

Also, due to the thinner market for bonds, it can be difficult to get current pricing. Bonds vary so much in their maturities, yields and the credit rating of the issuer that centralized trading is difficult.

However, FINRA introduced the Trade Reporting and Compliance Engine (TRACE) in 2002, which requires all broker-dealers to report OTC bond trades, thereby increasing transparency in the bond market.

Is Inflation a Risk for Fixed-Income Investors?

Yes, it is an additional risk for fixed-income investors. That’s because of persistent inflation’s erosion of the value of income that they receive. Many investors, no matter their stage in life, understand that a mix of growth and fixed-income investments is important to having enough money to last them throughout their lives.

Are Fixed-Income Securities Growth Investments?

No, because they don’t necessarily appreciate in value. The amount that you pay to buy a fixed-income security doesn’t increase as you await its return. Although you’re paid interest for buying the security, you get back just the amount that you put in.

Why Do Conservative Investors Like Fixed-Income Securities?

Investors with a conservative approach to investing tend to be more concerned about the risks to their investments than the relatively lower return they get compared to, for instance, equities. Preserving their capital is most important and fixed-income securities facilitate that goal.

The Bottom Line

The factors that most influence fixed-income securities are changes in interest rates, the risk that an issuer may default on its payments, and the risk that liquidity is not high enough to sell their securities in the secondary market (rather than hold them to maturity).