What are fixed income securities and how to invest?

Fixed income securities guarantee a stable and predictable cash flow, with a lower risk than shares. This is why they are among the instruments preferred by Italians and considered a safe investment to protect savings from inflation. But not only that. Since 2022, the rise in interest rates by central banks has rekindled attention on these assets, attracting even the most experienced investors, capable of taking advantage of the price variations of fixed income bonds linked to monetary policies: today, investing in fixed income securities allows you to lock in higher returns before rates fall.

In this guide, we analyze in detail what fixed income securities are, how they work, what advantages and risks they entail, providing all the useful information to understand their role in the financial markets and the most effective strategies based on different levels of risk.

What are Fixed Income Securities

Fixed income securities are a debt instrument that entitles the holder to receive predictable periodic returns. This flow of payments includes periodic interest (coupons) and the repayment of the nominal capital at maturity. In the case of so-called zero-Coupon securities, the right is to have the nominal value reimbursed at maturity in a single solution.

The term "fixed income" comes from the fact that the yield at maturity is known - both in amount and duration - and does not depend on the change in value, as instead happens with shares. The predictable yield helps protect the capital.

The issuers of these securities can be companies, states or supranational entities that thus borrow capital from the market for a predetermined period of time. In exchange for the money lent to the issuers, investors receive interest.

Types of fixed income securities

Fixed income investments include different types of financial instruments, each with specific characteristics in terms of yield, risk and duration. Let’s see the main ones below.

• Government bonds, such as Italian Btp, German Bunds and American Treasuries, considered among the safest instruments for investors who want to protect their savings.
• Corporate bonds, issued by companies to finance their activities. They can be investment grade or high yield depending on their creditworthiness.
• Certificates of deposit, represent an alternative to bonds. Issued by banks, they are a form of fixed-term deposit that gives the holder the right to reimbursement of the capital at maturity, plus interest.
• Fixed income funds and ETFs, are investment instruments that collect a diversified basket of bonds, reducing the overall risk.
• High yield bonds (high yield), issued by entities with a lower rating and therefore characterized by a higher risk, but also by a potential higher return.
• Convertible bonds, also issued by companies, which offer the possibility of being transformed into shares, allowing the investor to take profit from a possible increase in the price of the underlying security.
• Subordinated bonds, which offer higher interest rates, but involve a greater risk in the event of insolvency of the issuer.
• Zero coupon bonds, such as CCTs issued by the Italian Treasury, which do not provide for the payment of periodic coupons, but are issued at a discount and reimbursed at nominal value at maturity, generating a return given by the difference between the purchase price and the reimbursement price.

Characteristics of fixed income investments

Fixed income investments are characterized by the forecast of certain cash flows, thanks to the payment of periodic coupons and the reimbursement of the capital at maturity. Let’s see all the characteristics of fixed income securities below.

• Nominal value: corresponds to the amount paid to the investor at the maturity date.
• Market price: is the current price of the security on the secondary market. For example, by purchasing 10 BTPs, the total nominal value is 10,000 euros. However, the value of bonds can vary over time. If the market value of the security is 98, the value of the bonds in the portfolio will be 9,800 euros. If the market value is 102, the value of the bonds will be 10,200 euros.
• Coupon: is the amount of periodic interest due to the investor, the value of which is expressed as a percentage of the nominal value of the bond. For example, a BTP with a fixed coupon of 3% will pay 30 euros per year for every 1,000 euros of nominal value of the bond.
• Bond yield: indicates the expected return on the investment, expressed as an annual percentage. It takes into account the purchase price, the coupons or cash flows expected over the life of the bond and the repayment of the capital at maturity or at the time of redemption.
  Example: a yield of 4% means that the investment generates an average annual return of 4%. The yield of a bond is inversely proportional to its price: when the price increases, the quoted yield decreases, and vice versa.
• Maturity: The date on which the investor receives the repayment of the face value and any residual interest. Some fixed income securities do not have a maturity date, but pay a continuous income without maturity (“perpetual bonds”).
• Duration: A measure of the sensitivity of a bond’s price to changes in market interest rates. For example, if interest rates rise by 1%, a bond with an average duration of 5 years would likely lose about 5% of its value. If a bond’s duration were 10, then the same 1% increase in interest rates would cause it to lose about 10% of its value.
• Issuer: Fixed income securities can be issued by governments, companies or supranational entities whose creditworthiness affects the level of risk of the security.
• Credit Rating: expressed in classifications with values from triple AAA to D for default, it represents a judgment made by specialized companies (rating agencies) on the issuer’s ability to repay loans and helps investors define the risks implicit in the investment.
• Liquidity: defines the ease with which the security can be bought and sold on the secondary market before its maturity. A security listed on a regulated market (Mot, Tlx or similar), with a high trading volume and a small spread between the ask price and the bid price is more liquid than an unlisted security or a security listed on internal bank platforms, where liquidity is poor.

Advantages and risks of fixed income securities

Fixed income securities are particularly advantageous for investors who seek stability and predictable returns. Here are the main advantages:

• planning: fixed income coupon bonds guarantee predictable payments at regular intervals, in addition to the return of the capital at maturity, through the reimbursement of the nominal value;
• diversification: in addition to being considered a safe investment in periods of economic turbulence or recession, fixed income bonds have a lower volatility than stocks and allow you to diversify your portfolio by balancing investments in riskier assets;
• profit opportunities: fixed income investments traded on the capital market can be bought or sold before maturity. In addition, investors can choose between various types of bonds (government, corporate, high yield) based on their financial needs and risk tolerance.

Although they are considered relatively safe, fixed income investments do carry some risks to consider

• Potential loss: the actual value of a fixed income security may fluctuate and be lower than the repayment value over its life. If the investor decides to sell the security before maturity, he runs the risk of losing part of the invested capital.
• Interest rate risk: changes in the monetary policy of a central bank can affect the price and yield of a fixed income security. An increase in interest rates causes a fall in the price of the bond and vice versa.
• Default risk: an issuer with solvency problems that fails to repay the bonds may cause the partial or total loss of the invested capital. To assess the default risk, one can refer to the rating: in general, the higher the rating, the lower the default risk and the lower the yield of the security.
• Liquidity risk: If the fixed income security is traded on an illiquid market, the investor runs the risk of having to hold the investment until maturity or having to sell it before maturity at an unfavorable price.
• Inflation risk: Inflation creates uncertainty about the real value of the payments received. An inflation-linked fixed income security allows you to compensate for the reduction in purchasing power due to an increase in inflation.

When to invest in fixed income bonds?

The current economic environment is favorable for fixed income investments. Despite the start of a cycle of interest rate cuts by central banks, there are still several interesting opportunities in terms of returns on the bond market, both for investors who hold the securities until maturity and who aim to collect a pre-established income at regular intervals, and for more speculative investors who can sell the securities before maturity, taking advantage of the increase in market value due to the reduction in rates.

Original article published on Money.it Italy. Original title: Cosa sono i titoli a reddito fisso e come investire?