Thursday, March 6, 2014

Fixed Income - Basics

1. Fixed Income - Basic Concept

Fixed Income is interchangeably used as Debt or Bond. This is another asset class in securities market. By the term it can be understood that this type of security. In this type of securities there are two parties involved and those are as follows:
  • Issuer: Who is borrowing money from public or people or another financial institution (s).
  • Money Lender: Who lends money to the borrower (in this case issuer).
In this type of instrument, Issuer and Money Lender enters into an agreement (Bond) where Issuer agrees to return the principal with some interest to the Money Lender. Though this type of instrument is considered to be a very safe instrument, generally there is no guarantee that the Issuer will return the principal and interest to the Money Lender. In contrast to the Equity instrument, this type of instrument doesn't represent any ownership to the issuing company. This type of instrument generally have an maturity date - by when issuer agrees to return the borrowed principal along with charged interest. The liability (Debt) of the issuing company is only up to the maturity date.

There are various important attributes of a Fixed Income securities. Those will be discussed later in this document. Depending on the various parameters, Fixed Income securities can be further classified in other sub categories, those are listed in the later part of this document.

2. Characteristics of Fixed Income Securities

This section will describe the characteristics of a typical Fixed Income securities. In this context it is important to know the important parameters or attributes of this type of instruments. Following are the important parameters of this type of instruments:
  • Issuer: The issuing company that issued the particular Fixed Income security.
  • Maturity Date: It is the day when the issuing company is obliged to pay the maturity amount (the principal or what is mentioned in the fixed income certificate). If things go well, after this day the issuing company's obligation becomes zero (0).
  • Interest (or Coupon) Rate: In capital market terminology, the interest is also called coupon. Interest Rate is the rate at which the issuing company agrees to pay the interest (or coupon). This may be a fixed one or floating. Details of this will be discussed in later phase.
  • Interest (or Coupon) Payment Frequency: The frequency at which the issuing company agrees to pay the coupon to the money lender or buyer of the fixed income securities. Examples are Annually, Semi-Annually, Quarterly.
  • Principal Amount: The value written on the fixed income certificate. This is also called Face Value of a fixed income security. In reality this is the amount the issuer agrees to repay the principal amount to the bond holder or the money lender at the time of maturity.
  • Issuing Currency: The currency at which the fixed income security has been issued to public. Examples are INR, USD, GBP, JPY etc.
  • Interest (Coupon) Payment Currency: The currency at which coupons will be paid to the bond holder. Examples are INR, USD, GBP, JPY etc. Issuing Currency may differ from Interest (Coupon) Payment Currency.
One interesting thing to be noted that the name of a bond itself conveys the key features of a debt instrument. E.g., a GS CG2024 10.50% bond refers to a Central Government (CG) bond maturing in the year 2024 and paying a coupon at a rate of 10.50%.

3. Coupon and Discount Instrument

Depending on the nature of a fixed income security that can be termed as a Coupon or Discount type instrument. The basic difference between a Coupon and a Discount instrument is that for the first type of instrument periodic interest is paid to the bond holder while for the later type of instrument no periodic interest is paid to the bond holder but the instrument is issued at a discounted price. A Coupon type of instrument is issued at principal amount and issuer agrees to repay the principal at the time of maturity. Whereas for a Discount type of of instrument, the instrument is issued at a discounted price which is less than the Principal Amount and issuer agrees to repay the Principal Amount at the time of maturity.

More on this section will be discussed during corporate action management section.

4. Examples of Fixed Income Securities

Depending on the business nature of fixed income securities these can be categorized as the following types:

  • Corporate Bond
  • Government Bond
  • US Treasury
  • Municipal Bond
  • Collateral Mortgage Obligation
  • Collateral Mortgage Obligation Group
  • Agency Bond
  • Asset Swap Bond
  • Mortgage Backed Security and etc.
The details of these instruments will be described in later phase.

© Sumit Bhowmick

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