Understanding Fixed Income: Benefits & Risks of Fixed Income Products
Benefits of Fixed Income Products:
Edna and Jonah were glad to learn basics of Interest Rate, but they could not figure out why they should invest in it.
The Financial Manager in the bank told them that interest rate products are called FIXED INCOME PRODUCTS because you know right at the beginning what the returns are in this investment so your income is “fixed”. This is unlike the stock market which can be very erratic. Due to the routine nature of the income, they are considered safer than stocks at most times.
Interest Rate Products also have an inverse relationship to the stock market. When the stock market is booming, the Fixed Income Products have low demand, and when the stock market is falling, demand for Fixed Income increases as it is considered much safer.
The main reason why someone would invest in Fixed Income products is because they know what they will get at the end and can plan accordingly.
Risks of Fixed Income Products:
Interest Rate Risk:
Interest Rate Risk means that the interest rate changes after you buy the bond.
This means supposed you buy a bond with a fixed interest rate of 3.5%. While you hold the bond, the interest rate goes up to 5%. This means, if you want to sell your bond, fewer people will buy it as they can now get 5% by buying a new bond.
But the opposite is also true, if the interest rate goes down to 1% then more people will want your bond as it pays more interest than the current rate, so the price of your bond will go up.
Credit or Default Risk
There is always a risk that the company or government issuing the bond to you could go bankrupt and not repay the principal and the interest. This is called Default Risk. Companies or Governments have credit ratings that are issued by ratings agencies that say what is the likelihood of the institution defaulting on the loan. Higher credit rating the less likelihood of defaulting on the bond.
If an institution has a low credit rating, the bind will always pay a higher interest rate so that it is more attractive for the investor.
“Liquid” in financial terms means having easy access to cash. For example, if your entire portfolio is in stocks and you urgently need money then you have to sell the stocks to get the cash. In this case, your portfolio would not be considered liquid. On the other hand if you have a large cash balance, you can easily access money to pay for things so you are considered very liquid.
The same is applied to the fixed income market. Liquity Risk refers to the ability of the company to pay back your loan if you decide to cash out early.