Fixed interest basics
While fixed interest doesn't deliver the highs of shares or property trust investments, it tends not to suffer the lows that these investments can in more volatile times.
Types of fixed interest securities
Fixed interest investments can be issued by the Commonwealth Government, state governments, semi-government authorities, banks and other corporations, both locally and overseas, to raise capital for projects.
Fixed interest investments usually have longer investment terms than cash investments. Australian bond maturities range from one to 10 years while US bonds can extend up to 30 years.
Investment in both international and Australian fixed interest securities has two major benefits for investors. It increases diversification, which lowers risk, and it provides opportunities for enhanced returns without resorting to lower grade, higher risk debt. The international bond market includes over 3,000 securities compared to around 300 in the Australian market.
Types of fixed interest securities
The main types of fixed interest securities are:
- Government bonds - issued directly by a government and are explicitly guaranteed. For instance, in Australia the Federal Government issues commonwealth securities to help pay for major government projects;
- Semi-government bonds - not issued directly by a government but might have a direct or implied guarantee. For instance, state governments and other entities that have a government guarantee, (like the World Bank), issue bonds to support their financial needs or to finance public projects; and
- Corporate bonds - issued by large public companies to fund expansion and other major projects. Corporate bonds differ in two important ways to government bonds - yield and credit quality. Generally, corporate bonds are thought to have a higher level of risk than government or semi-government bonds, so they typically offer higher interest rates.
- Hybrids - have characteristics of both equity and fixed interest securities. Convertible bonds, for example, commence as bonds but can be converted into equity at a future date. These types of securities have higher risk than government or corporate bonds as they are less secured. This means they come further down the repayment line if the issuer defaults on the loan.
How fixed interest markets work
Bonds operate like an IOU, whereby you lend your money to the issuer for a set period of time, in return for interest paid over the term of your investment. Your investment, or capital, is then paid back to you in full at the end of the investment term.
Fixed interest securities can be traded on the secondary market before their maturity. This is usually the domain of professional investors such as the large banks, brokers and fund managers who trade securities with the aim of profiting from price fluctuations.
Fixed interest is a low to medium risk investment suitable for investors with a timeframe of three years or more.
In addition to providing a regular income stream - an important feature for many investors - fixed interest can provide a stabilizing effect during periods of share market volatility.
As their name suggests, fixed interest securities make regular interest payments. Interest rates can be fixed or floating. Fixed rates are set for the life of a security, while floating rates are reset periodically.
Total bond returns can include income from interest payments and growth from price fluctuations. Bond yields are calculated by dividing annual income by market value. A bond's issue price is called its par value and its regular interest is called a "coupon payment". If you hold a bond until maturity your total yield equals the coupon interest rate.
If you buy or sell a bond on the secondary market your yield and total returns can vary. In fact, bond interest rates and prices can fluctuate regularly based on the economic outlook. Bonds can provide capital growth (and loss) when sold prior to the maturity date for a higher (or lower) price.
If you hold your bond until maturity interest rate risk is less of an issue. You will receive set income payments at the agreed interest rate for the life of the bond and your capital is repaid when the bond matures.
Credit risk refers to the risk of an issuer defaulting on repayment of capital. Credit ratings provide a good indication of the risk level associated with the issuer. Bond issues are rated by independent rating agencies like Standard & Poor's. The higher the rating the less likelihood of the issuer defaulting on repaying your capital. AAA is the highest rating awarded for long term issuers while BB and below is the lowest and is usually given to more risky or speculative investments. Usually, the higher the risk, the higher the yield.
Accessing fixed interest markets
You can invest in fixed interest investments directly or through a managed fund. Managed funds provide a way of accessing a diversified portfolio of securities, which can include a mix of Australian or international government and corporate fixed interest investments, or a combination of both.