Chapter 8 Lesson A - Fixed Income Securities

Introduction of the Host
Mrs.Geetha Dasaraty is a commerce graduate with a Masters in Business Administration specialising in finance. Her stint with a Coimbatore based company and later with a consulting firm in Chennai has provided her with a decade of experience in project finance and appraisals, accounting and tax laws. She is a freelance writer and money matters are her forte. She is currently pursuing her final course in Company Secretaryship and is doing a course on Vaishnavism. She has a passion for literature and Carnatic music. She is also a violinist.

About the Class
We bring you an online class titled 'Elementary Finance'. This will have 12 lessons - one a month. Each lesson is further subdivided into 4 chapters. And we will give you one new chapter every week.

Chapter 8 Lesson A - Investing in fixed income securities

In this lesson we will see what fixed income securities are.

Fixed income securities are securities that earn a current fixed income. They are safe, secure and are less risky as an investment. Fixed income securities afford liquidity. These investments perform well under stable economic conditions.
Some of the fixed income securities are:

• Corporate bonds
• Government bonds
• Municipal bonds
• Short-term debt securities.

What is a bond?
A bond is a certificate stating that a company or Government has taken loans or funds from you. And assuring you a fixed future interest and repayment of principal.

• Bonds are a good investment. They are safe investments and they rank before equity shareholders in the distribution of earnings as well as in the case of winding up.
• They procure a fixed rate of interest unlike shares.
  However, bonds do not carry voting rights and also do not have a right to share in the increased profits.

Terms of bonds.

• Par Value: The par value of a bond is the face value of the bond.
• Coupon rate: The coupon rate is the nominal interest rate, which ascertains the actual interest to be received on a bond. It is generally stated as an annual interest.
• Maturity date: The maturity date is the date on which the bond principal has to be repaid.
• Indenture: This is a legal agreement, which outlines details of the bond issue.
• Trustee: A trustee is the third party with whom the indenture is made. The trustee checks whether the terms of the indenture are carried out.
• Yield: This represents the effective rate of interest on the bond. Where a bond is bought at a rate lower than the face value, the yield will be higher than the coupon rate and vice versa.
• Call Provision: This provision allows the corporation to repurchase or call back the bond from the holders at specified rates.
• Sinking funds: In such bonds, the money is set aside in a sinking fund for the repayment of the debt.

Types of bonds:

• Mortgage bonds: These are bonds secured on physical properties. Where there is any default, the bondholders can foreclose on the property and sell it.
• Debentures: These are secured bonds. A debenture is an instrument, which acknowledges a debt and is issued under the common seal of a company. It contains a contract for repayment of the principal on a specified date and also for the payment of interest at a fixed rate. They have a floating charge on all movable and immovable assets of the company. Debentures may be mortgage debentures or simple debentures, redeemable or irredeemable debentures, registered and bearer debentures and convertible or non-convertible debentures.
• Convertible bonds: These bonds are a type of debentures, which may be converted into other securities like shares, at a fixed price. They have the features of both bonds and shares as they provide fixed interest and at the same time allow for participation in profits.
• Income bonds: In the case of income bonds interest will be paid only if income is earned.
• Tax-exempt bonds: Bonds exempt from tax are generally municipal bonds where the interest is not taxable. Municipal bonds may carry an interest lower than the regular bonds.
• Government securities: These are Government guaranteed bonds issued by Corporations, public sector undertakings etc. to meet long term financial requirements. These are earned for periods ranging from 5 to 21 years. The interest returns are lower while there is greater degree of safety for the principal.
• Zero Coupon bonds: Zero coupon bonds are not fixed income securities in the strict sense because they do not yield a fixed periodic income. Here the income instead of being paid monthly is added to the principal and the accumulated interest and principal will be paid on maturity. As a result of this compounded interest the returns on the original investment will be higher.
• Serial Bonds: These bonds mature in instalments over time rather than at a maturity date.

How do you select a bond?
Consider these factors before going in for a bond.

• Ratings of the bond: The ratings of the bond reflect the companies' ability to repay the principal and interest. They help to decide the ideal risk, interest and period of investment. The highest rating is AAA, which indicates highest safety for repayment of principal and interest. In India, the minimum rating for reasonable safety of investments is FA-. It may be noted that the higher the rating, the lower are the interest returns.
• Maturity: Maturity relates to the period for which investment is made. Generally, instruments with a shorter maturity yield lower returns when compared with those with longer maturity.
• Features: Ascertain if the bonds have a call option, which implies that the issuing company can redeem its bonds after a certain period, before the maturity date. In cases where the bonds have a call option, there is a chance that you might stand to lose. Bonds are usually called if their interest rates are higher than the going rates. Exercise the call option after due assessment of your financial requirements.
• Some bonds may be issued with convertible features by which these bonds are converted into shares or stock in future. These bonds ensure fixed interest while also providing for possible appreciation in capital.
• Yield and maturity: Some bonds may be issued at a premium when
  a. The maturity is not long
  b. The market rate of interest is lower than the bond interest rate.
  c. The business of the company involves fewer risks.
  Sometimes bonds may also be issued at a discount, i.e. lower than the face value.
  The issue price of the bond whether at a premium or discount is crucial for the yield.
  
  Some of the popular bonds and Government securities are:
  v 8% RBI Relief Bonds (Tax free)
  v 8.75% National Highway Authority of India.
  v 11% National Thermal Power Corporation.
  v 11% Power Finance Corporation.
  v 10.5% TamilNadu Government Loan.
  v 10.5% Konkan Railway Corporation.
  v Bonds issued by NABARD.
  v 8.75% Rural Electrification Corporation of India.

Calculating the yield
Bonds are evaluated on returns like current yield, yield to call and realised yield.

• Current yield = Annual Payment Interest
                          -------------------------
                                
Current Price
The drawback here is that this ratio does not consider the maturity date.

• Yield to maturity: this takes into account the date on which the bond matures. This ratio calculates the actual returns from interest and capital gains.
• Yield to call: This ratio takes into account the call price when the bond is called back.
• Realised yield: A bond can be traded in before it matures. Under this method the future price is used in the place of par value.

Other Fixed Income Securities.
In addition to bonds and shares there are other investments of short-term nature that yield fixed income.

• Certificate of Deposits (CD's): These are instruments issued by commercial banks and other financial institutions. The maturity period on this varies from a few months to years.
• Commercial Paper: Commercial paper is issued by big companies to the public. These are usually for a few lakhs. These are unsecured promissory notes. They carry a higher percentage of interest than CD's. The risk on purchasing commercial papers depends on the company's credit rating.
• Treasury Bills: These bills are backed by the Government and hence have a maximum maturity period of one year and a common maturity period of 91 days to 182 days. Though they do not carry interest they are sold at a discount and redeemed at face value at the maturity date. These bills are highly liquid, as there is a good resale market for them.
• Money Market Funds: These are special forms of mutual funds. A person can have a diversified portfolio with CD's, treasury bills and other securities with a small investment. These funds are conservative.

In the next chapter we will deal with Mutual Funds.

Questions on Chapter 7 Lesson D
1. What are the various types of stock?
2. How can you calculate the return on shares?