Fixed Interest Investing
Written and accurate as at: Nov 02, 2015 Current Stats & Facts
Asset class - fixed interest
Fixed interest is quite a diverse investment category.
The fixed interest asset class includes investments such as term deposits, government bonds, corporate bonds and debentures. These are often called income securities. You can also invest in international fixed interest which includes bonds issued by foreign governments and corporates.
For the majority of fixed interest investments, the interest rate and timeframe for investment will be set from the outset – that is fixed.
A term deposit may offer a more attractive interest rate than a cash rate as it generally locks in your investment for a longer time period.
A term deposit only offers an income return (the interest rate) and does not offer any capital growth.
Another example of a fixed interest investment is a government bond.
Government bonds
Government bonds involve lending an amount of money to the government for a specified timeframe and the issuing government will commit to pay you an interest amount, most commonly referred to as the coupon rate. If you hold this investment to maturity (the specified timeframe) you will receive your capital and your coupon (interest) on the investment. Depending on the bond, you may also receive coupon payments during the year as well as on maturity. So if you invested $1,000 in a government bond for 12 months with a coupon rate of 6% pa, you will receive $1,060 at maturity ($1,000 + $60 interest).
Corporate bonds
Corporate bonds are very similar to government bonds however you would be lending to a public or private company rather than the government.
The risk of investing in corporate bonds is usually considered greater than investing in government bonds as the company guaranteeing the capital and interest, may, for example, go out of business.
Government bonds have the security of being backed by the Reserve Bank of Australia. If you are investing in corporate bonds, it is important to research the company to ensure they have the capacity to repay your capital and the interest due to you.
So, all things being equal, you would expect to receive a slightly higher coupon or interest rate for a corporate bond as the investment risk is higher.
Secondary market for bonds
The main difference between a term deposit and a bond is that a bond may not need to be held until maturity – it can be sold to another investor prior to the maturity date.
This then creates a secondary market for bonds.
Remember we earlier explained that the interest rate paid on the bond is generally fixed.
On the secondary market, the coupon remains fixed but the value or price of the bond changes to reflect the current market conditions (in particular, the interest rate at the time).
Therefore the bond capital value can increase or decrease. Generally, the market price of a bond will increase if market interest rates fall and vice versa.
This results in the potential to earn interest from a bond as well as growth or decline in the capital value of the bond.
Secondary market for bonds
Many managed funds and super funds that invest in fixed interest, access fixed interest bonds on the secondary market and therefore the return on these bonds will depend on the price paid for them in the secondary market. This is best illustrated in the example below.
Let's say, you invested $10,000 in a government bond for 12 months at 6% coupon rate.
If you hold the bond for 12 months you will receive $10,600.
After you invested in your bond, the market interest rate dropped to 4% for new bonds issued now with the same features.
In this case the capital value of your bond will increase as you are getting 2% more income on your bond than other investors would get if they were to buy a new bond.
Therefore your bond becomes more attractive to buyers and this is reflected by a higher price for your bond compared to the amount you paid for it.
You could now sell your bond to someone else for more than $10,000 you paid, thereby making a capital gain.
Secondary market for bonds
However, if the market interest rate instead rose to 8%, the capital value of your bond would reduce as your bond will return 2% less than the market rate on new bonds. Your bond is less attractive to buyers and you need to reduce its price to attract buyers.
To help diversify, you can invest in bonds with both the government and the corporate sector, and perhaps within Australia and overseas.
This spreads the risk of default.
In addition, you can buy various income securities with different maturities. This helps manage your reinvestment risk, whereby not all your money is maturing at once.