Fixed income securities return a fixed interest (coupon) rate on a periodic basis (monthly or quarterly) for a fixed period of time (maturity date). From an investor’s perspective, investments are essentially loans to a borrower who pays interest and makes a promise to repay the loan at a future date. There can be collateral for the loan, or a guarantee to be repaid before other creditors of the borrower, or simply a loan based on the creditworthiness of the borrower. Investments in fixed income securities are exposed to any of the following risks:
- Default Risk
- Call Risk
- Reinvestment Rate Risk
- Price Risk
Default and call risk cannot be eliminated which is why interest rates paid are adjusted to compensate investors to assume this risk. Reinvestment rate and price risk can be virtually eliminated by matching the maturity dates of the fixed income security with the date the funds are needed. This concept in practice is utilized through a statistical measure known as the duration of the fixed income security or portfolio. The duration is defined as the average weighted date that the invested funds are returned to investors.
Reinvestment risk and price risks both arise from uncertainty about future market interest rates. The impact of changes in market interest rates has an opposite effect on reinvestment and price risks. Increasing market interest rate lower the price of fixed income securities while increases the interest rates at which interest payments can be reinvested. The investment concept of duration helps balance these two risks when evaluating fixed income securities with different maturity dates.
Fixed income securities can be classified according to the structure of interest rates based in terms of maturity dates as follows:
A financial advisor can help you determine the appropriate proportions for your assets that should be held in cash equivalents to meet your near term liquidity needs, and notes and bonds for your investment portfolio. The asset allocation decision between equities and fixed income securities is an important investment decision that impacts reaching your True North.
