What is fixed income security? Explain different types of fixed income securities. [3+12]

Fixed Income Security

Fixed income securities are financial instruments that provide investors with periodic income in the form of interest payments and the return of the principal amount at maturity. These securities are considered low-risk investments compared to equities because they offer predictable cash flows. Fixed income securities are primarily debt instruments issued by governments, corporations, or other entities to raise capital. Investors who purchase these securities essentially lend money to the issuer in exchange for fixed interest payments and the repayment of the principal at a predetermined date.

Fixed income securities are widely used in portfolio diversification due to their stability and lower volatility compared to equities. They play a crucial role in managing risk and providing steady income streams for investors.

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Types of Fixed Income Securities

Fixed income securities can be broadly categorized into several types based on the issuer, maturity, and structure. Below is a detailed explanation of the different types:

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1. Government Securities

Government securities are debt instruments issued by national governments to finance their expenditures. These are considered among the safest investments because they are backed by the government’s ability to tax and print money.

a. Treasury Bills (T-Bills)

• Definition: Short-term debt instruments issued by the government with maturities ranging from a few days to one year.
• Features:
  • Sold at a discount to their face value.
  • No periodic interest payments; investors earn the difference between the purchase price and the face value at maturity.
  • Highly liquid and considered risk-free.
• Example: In Nepal, the Nepal Rastra Bank (NRB) issues T-Bills to manage liquidity in the economy.

b. Government Bonds (G-Secs)

• Definition: Long-term debt instruments issued by the government with maturities typically ranging from 2 to 30 years.
• Features:
  • Pay periodic interest (coupon payments) and return the principal at maturity.
  • Can be traded in the secondary market before maturity.
  • Interest rates are influenced by market conditions and government policies.
• Example: Nepal Government Securities (NGS) issued by the NRB.

c. Savings Bonds

• Definition: Long-term, low-risk securities issued by governments, often targeted at retail investors.
• Features:
  • Offer fixed interest rates for a specified period (e.g., 5, 10, or 20 years).
  • Cannot be traded in the secondary market; must be held until maturity.
  • Often exempt from state and local taxes.
• Example: Nepal’s National Savings Certificate (NSC) or Public Provident Fund (PPF)-like instruments.

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2. Corporate Securities

Corporate securities are debt instruments issued by private companies to raise capital for expansion, research, or other business needs. These securities carry higher risk than government securities but offer higher yields.

a. Corporate Bonds

• Definition: Long-term debt instruments issued by corporations with maturities ranging from 5 to 30 years.
• Features:
  • Pay fixed interest (coupon) payments periodically (e.g., semi-annually or annually).
  • Principal is repaid at maturity.
  • Riskier than government bonds but offer higher interest rates.
  • Can be secured (backed by assets) or unsecured (debentures).
• Example: Bonds issued by Nepal Investment Bank Limited (NIBL) or Global IME Bank.

b. Debentures

• Definition: Unsecured long-term debt instruments issued by corporations.
• Features:
  • Not backed by specific assets; rely on the issuer’s creditworthiness.
  • Higher interest rates compared to secured bonds due to increased risk.
  • Can be convertible (can be converted into equity shares) or non-convertible.
• Example: Nepal Telecom’s debentures.

c. Commercial Paper (CP)

• Definition: Short-term, unsecured promissory notes issued by corporations to meet short-term liabilities.
• Features:
  • Maturities range from a few days to 270 days.
  • Sold at a discount or with a stated interest rate.
  • Used by large, creditworthy companies to raise short-term funds.
• Example: Commercial paper issued by Nepal Bank Limited (NBL).

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3. Mortgage-Backed Securities (MBS)

Mortgage-backed securities are asset-backed securities collateralized by mortgage loans. These securities pool together multiple mortgages and sell shares of the pool to investors.

a. Pass-Through Securities

• Definition: Investors receive monthly payments that pass through from the underlying mortgage loans, including principal and interest.
• Features:
  • Prepayment risk (if homeowners repay mortgages early, investors receive principal back sooner).
  • Interest rates are tied to mortgage rates.
• Example: Fannie Mae or Freddie Mac securities (though less common in Nepal, similar instruments may exist in structured finance products).

b. Collateralized Mortgage Obligations (CMOs)

• Definition: Structured securities that divide mortgage pools into different tranches (classes) with varying risks and maturities.
• Features:
  • Tranches are prioritized for repayment (e.g., some tranches receive principal first).
  • Reduces prepayment risk compared to pass-through securities.
• Example: CMOs issued by financial institutions in developed markets (rare in Nepal but conceptually applicable).

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4. Money Market Instruments

Money market instruments are short-term, highly liquid debt securities with maturities of one year or less. These are used by investors to park funds temporarily while earning interest.

a. Certificates of Deposit (CDs)

• Definition: Time deposits issued by banks with fixed interest rates and specific maturity dates.
• Features:
  • Can be negotiable (transferable) or non-negotiable.
  • Penalties for early withdrawal.
  • Offer higher interest rates than regular savings accounts.
• Example: CDs offered by Nepal SBI Bank or Standard Chartered Bank Nepal.

b. Banker’s Acceptances (BAs)

• Definition: Short-term credit instruments issued by banks that guarantee payment to the holder.
• Features:
  • Used in international trade to finance imports/exports.
  • Maturities range from 30 to 180 days.
  • Low risk due to bank backing.
• Example: Used in Nepal’s trade finance transactions.

c. Repurchase Agreements (Repos)

• Definition: Short-term loans where securities (e.g., government bonds) are sold with an agreement to repurchase them at a higher price.
• Features:
  • Essentially a collateralized loan.
  • Used by banks and financial institutions to manage liquidity.
  • Interest rate is the difference between the sale and repurchase price.
• Example: Repos conducted between commercial banks and the Nepal Rastra Bank (NRB).

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5. Other Fixed Income Securities

a. Preferred Stocks (with Fixed Dividends)

• Definition: Hybrid securities that combine features of debt and equity. Preferred stocks pay fixed dividends and have priority over common stocks in liquidation.
• Features:
  • Dividends are fixed and must be paid before common stock dividends.
  • Often have no maturity date (perpetual) or a call option for the issuer.
  • Can be convertible into common stock.
• Example: Preferred shares issued by Nepal Investment Bank Limited (NIBL).

b. Floating Rate Notes (FRNs)

• Definition: Debt instruments with variable interest rates that adjust periodically based on a benchmark (e.g., LIBOR, NRB policy rate).
• Features:
  • Reduce interest rate risk for investors.
  • Issuers benefit from lower interest payments when rates fall.
  • Common in inflationary environments.
• Example: FRNs issued by multinational corporations operating in Nepal.

c. Inflation-Linked Securities

• Definition: Securities whose interest payments and principal are adjusted based on inflation rates.
• Features:
  • Protect investors from inflation risk.
  • Principal and coupon payments increase with inflation.
  • Example: Inflation-Indexed Bonds (IIBs) issued by governments (e.g., UK’s Linkers or US TIPS).
• Example in Nepal: Hypothetical instruments linked to the Consumer Price Index (CPI).

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Comparison Table: Key Types of Fixed Income Securities

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Factors Influencing the Choice of Fixed Income Securities

Investors and issuers consider several factors when selecting fixed income securities:

1. Risk Tolerance: Government securities are safer but offer lower returns, while corporate bonds and debentures carry higher risk but provide higher yields.
2. Maturity: Short-term securities (e.g., T-Bills, CDs) offer liquidity, while long-term securities (e.g., bonds) provide higher interest rates.
3. Interest Rate Environment: In rising interest rate environments, short-term securities are preferred to avoid reinvestment risk.
4. Tax Implications: Some securities (e.g., government bonds) offer tax advantages.
5. Liquidity Needs: Highly liquid securities (e.g., T-Bills, repos) are suitable for short-term investments.
6. Inflation Hedging: Inflation-linked securities protect against erosion of purchasing power.

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Role of Fixed Income Securities in Portfolio Management

Fixed income securities play a vital role in diversifying investment portfolios. They provide:

• Stable Income: Regular interest payments help meet cash flow needs.
• Capital Preservation: Lower volatility compared to equities.
• Risk Mitigation: Balancing riskier assets (e.g., stocks) with safer fixed income instruments.
• Liquidity Management: Short-term securities help meet unexpected financial needs.

In Nepal’s context, fixed income securities such as Nepal Government Securities (NGS), T-Bills, and corporate bonds are popular among institutional and retail investors for their stability and relatively higher returns compared to savings accounts. However, the market is less developed compared to global counterparts, and investors must carefully assess credit risk and liquidity constraints.