Fixed income investment: The miracle and mirage
Fixed income investment is any investment that offers a fixed or guaranteed rate of return to the investor over a specified period of time. Typical examples of fixed income investments are bonds issued by the government or corporate entities. These investments have fixed rate of returns on the face value, and once purchased, investors are sure to receive the guaranteed returns over the tenor of the investment. Because of this, there is a general misconception that, fixed income investments are safe investments since they offer fixed or guaranteed returns. Nevertheless, it is worth noting that, fixed income investments just like any other investment have some associated risks which are worth considering by investors before reaching any investment decision. In this regard, this article seeks to shed light on some inherent upsides and downsides of fixed income investment that investors should be aware of.
The upsides or benefits of fixed income investment
Certainty of future returns is one of the main benefits of fixed income investment. Since the coupon or interest rate on fixed income investment is static, investors are assured of a steady return on the investment over the investment horizon with the only caveat that, the issuer of the security remains solvent over the tenor of the security – a rare event. The future cash flows of fixed income investments such as bonds are the periodic coupon payment and repayment of the principal on maturity of the investment.
The bond prospectus usually contains vital information regarding the source of cash flow for coupon payment and principal redemption. The frequency of coupon payment and modalities for payment are all spelt out in the bond prospectus. In effect, coupons and principal repayments are contractually transparent and can be easily predicted with the only caveat of insolvency alluded to above. For example, if you invest in 5-year Government of Ghana (GoG) bonds offering an annual coupon of 21 per cent, then you will receive 21 per cent return on your investment every year for five years. Contrary to a variable income security, there is absolutely no control over how much return you earn per year. For the sake of simplicity, the above scenario considers a situation where the investor buys and holds the bond to maturity without trading on the secondary market. Once the notion of trading is introduced, the narrative changes which will be the focus of discussion in subsequent articles. Unlike equity investment whose returns are very uncertain and volatile, the main goal of fixed income investment is generating a stable amount of income to the investor and not on the appreciation of the capital. Fixed income investments are therefore the most preferred assets class by investors during periods of economic downturn.
Fixed income investments are also very essential in the construction of a well-diversified portfolio. A well-balanced investment portfolio combines high-risk investments that promise higher returns as well as low-risk investments that offer lower returns but can also guarantee the stability of the principal. This is where fixed income investments come in handy in portfolio construction as they help in stabilizing returns whenever any adverse situation arises in the market. A portfolio that is much focused on excessive return at the expense of preserving the invested capital has the tendency to crush down as a result of unnecessary risk-taking. To safeguard your financial future, it is very essential to invest an equal portion in fixed income securities. Should the high-risk investments be wiped out, you will still have the fixed income securities to fall on. Therefore, fixed income investments help to immunize the entire portfolio from too much volatilities and potentially stabilize the overall return. This enables the investor to have access to relatively stable income to support his or her preferred lifestyle.
Payment Priority during Liquidation
In the rare event of a company being liquidated, fixed income investors enjoy some preference over other investors. Fixed income securities such as bonds represent debt security of the issuing entity. In times of liquidation, debts rank higher than other category of investors such as shareholders. Companies are therefore obliged to redeem their outstanding obligation to debt holders in the form of fixed income investment in the companies. Thus, bond holders will be paid first from the proceeds of the liquidated assets of the company. As such, by investing in company bonds rather than equity, investors are better assured of protection of their investments in the extreme event of company being declared bankrupt and eventually liquidated.
Investors normally undertake investments to meet specific investment goals. Fixed income investments are meant to offer a stable flow of income over a defined period of time. Nevertheless, unexpected circumstances may happen that may trigger the need to sell the fixed income investment to raise money to address that urgent or emergency need. In such situation, fixed income investors who invest in liquid securities with active secondary market can resort to trading the security on the secondary market. In the case of Ghana, the investor can trade the security through licensed dealers on the Ghana Fixed Income Market (GFIM) which is the secondary market for the trading of fixed income or debt instruments. However, we need to emphasize that, depending on the time to maturity of the investment and the prevailing market interest rate, the investment can be either traded or sold at a premium, in which case the investor makes profit on the invested capital or at a discount, whereby the investor loses portion of the invested principal or capital. In either case, the ultimate aim of getting liquidity to address your emergencies is met.
The downsides of fixed income investment
Default risk/credit risk
One of the inherent downsides or risks in investment in fixed income securities such as bonds is the possibility of default or credit risk on the part of the issuer. Fixed income investment represents a contractual agreement whereby the issuer of the debt security agrees to pay a fixed rate of return to the bond holder over a period of time. However, circumstances may arise such as the deterioration in the economic and operating environment of the issuing firm. This may have significant adverse impact on the cash flow positions of the issuing firm, affecting its ability to honour payment obligations. In such a case, the bond is said to be in default. The default or credit risk is a function of the issuer. Bonds issued by sovereign states such as GoG bonds are normally considered risk free.
However, this position has been recently challenged following default by some sovereign nations. Investments in corporate bonds are riskier compared to government bonds. Default risk is of greater concern to return seeking investors who have exposures in high yielding or non-investment grade bond. Some bond prospectus contain default provisions which pre-inform investors on the likely remedies should the unexpected happen. Investors are therefore encouraged to fully study and understand the terms of the bond prospectus before any investment decision is reached.
Inflation risk is another risk worth considering before investing in fixed income instruments such as bonds. This is especially so for investors or retired workers who are seeking to live off their bond income. Inflation risk is the risk that inflation rate will rise thereby eroding the purchasing power of your income from the bond investment. As stated earlier, fixed income investments offer a guaranteed rate of return. In inflationary period, the nominal rate of return which is coupon or interest rate remains unchanged.
However, the real rate of returns which accounts for the effect of inflation tends to decrease. Building on the example cited earlier above, where the investor receives, 21 per cent per annum on a 5-year GoG bond, let’s assume now that annual inflation averages 10 per cent. In this situation, though the investor still receives 21 per cent return on the investment, real returns is 11 per cent. This means that, with the same amount of returns, the investor can now purchase fewer goods. To mitigate this risk, some jurisdictions or markets such as the United States have the Treasury Inflation-Protected Securities (TIPS). The payment of the principal of the TIPS is adjusted to reflect the inflation component. Investors receive an amount higher than the principal following the redemption of the bond on maturity. The prevailing inflation rate is also factored into the interest calculation, thus interest payments on TIPS are varied though the coupon is fixed.
Presently in Ghana, there is no inflation linked bond being traded on the secondary markets, thus bond investors in Ghana are not insulated from inflation risk. This is therefore a risk worth considering.
Interest rate and re-investment risk
Interest rate is the risk as a result of changes in the prevailing market interest rate which ultimately affect the price of bond. The price of a bond is inversely related to the interest rate. The higher the interest rate, the lower the price and the lower the interest rate the higher the price. Interest rate risk is therefore a major concern for fixed income securities that are bought with the intention to sell. As the interest rate rises, bond price decreases. This is because new bonds are issued at a higher rate and become more attractive than existing bonds. Investors therefore pay a discount or lower amount for old bonds offering lower coupons. The reverse also holds that, as interest rate falls, new bonds are issued at a lower coupon or interest rate. Investors are willing to pay a premium in order to acquire existing high coupon paying bonds. This causes the price of the bonds to rise. Investors are able to make profit in case they sell their bonds during periods of declining interest rate.
Also, the changes in the interest rate present a re-investment risk. Re-investment risk is the risk that the coupon payment or principal payment will be invested at different rates from the initial investment. Re-investment risk is a major source of risk for bond investors with the aim of re-investing or rolling over their coupon payment or principal. When interest rate falls, coupon and principal payment are re-invested at a lower interest rate which reduces the income stream of the investor. When interest rate rises, coupon and principal payments are re-invested at a higher rate, boosting the investor’s income.
Fixed income investments are considered to be more conservative form of investments with relatively stable returns. The underlying benefits of the fixed income investments make them favourable options for anyone who wants to reduce risk and still earn descent returns.
Nonetheless, they are not immune from risks. Investors are therefore cautioned to be aware of their own investment objectives and risk tolerance level. They should better study and understand the prospectus of any fixed income investment vehicle to make informed investment decisions.
By Daniel Taylor & Bernard Sarpong