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For example, if you lend money to a borrower and the borrower has to pay interest once a
month, you have been issued a fixed-income security. When a company does this, it is often
called a bond or corporate bank debt (although "preferred stock" is also sometimes considered to
be fixed income). Sometimes people misspeak when they talk about fixed income. Bonds
actually have higher risk, while notes and bills have less risk because these are issued by
government agencies.
The term fixed income is also applied to a person's income that does not vary with each period.
This can include income derived from fixed-income investments such as bonds and preferred
stocks or pensions that guarantee a fixed income. When pensioners or retirees are dependent on
their pension as their dominant source of income, the term "fixed income" can also carry the
implication that they have relatively limited discretionary income or have little financial freedom
to make large expenditures.
Fixed-income securities can be contrasted with variable return securities such as stocks. To
understand the difference between stocks and bonds, you have to understand a company's
motivation. A company wants to raise money, and it doesn't want to wait until it has earned
enough through ongoing operations (selling products or providing services). In order for a
company to grow as a business, it often must raise money; to finance an acquisition, buy
equipment or land or invest in new product development. Investors will only give money to the
company if they believe that they will be given something in return commensurate with the risk
profile of the company. The company can either pledge a part of itself, by giving equity in the
company (stock), or the company can give a promise to pay regular interest and repay principal
on the loan (bond or bank loan) or (preferred stock).
Robin Kapoor, F-12 2
Fixed Income Securities IFS
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The purpose of owning Income Securities is quite simply the generation of a secure cash
flow that can either be spent or reinvested at prevailing interest rates (i.e., compounded) until it
is needed.
The classical long term goal of an Investment Program is to live off the income produced by
one's assets, without ever having to invade the principal. Therefore, it should be clear that it is
never smart, or savvy either to defer the receipt of income for any reason, ever, or to put off the
development of the income stream until the last minute. This is part of what Asset Allocation is
all about! Done using the Working Capital Model, it assures the constant growth of the income
contribution to the portfolio.
Investing in Income Securities is never a hedge against something that may or may not happen
in the future, nor is it a place to stash your stash until some other event takes place. Investment
Income comes in just two varieties: interest on debt securities and dividends on stocks and
other hybrid securities, such as Preferred Stocks and Closed End Mutual Funds/Investment
Companies that are distributed to investors in the form of Equities. Capital Gains income is a
real possibility as well, but it is not considered part of the Fixed, Base Income. Rents and
royalties can be classified as fixed and/or variable income.
Income Investing has always been the orphan of the Investment World because it just doesn't
generate the hype and excitement that the "Shock" Market routinely provides. Still, it is
important for investors to understand that there is as much of a need for income in the day to day
or short run of running an investment portfolio as there is the obvious need for income in a
person's retirement years.
Income Securities generally trade in larger dollar quantities than stocks, particularly when
initially sold to the public, and the mark up on them is both invisible and huge... upwards of 3%
in most instances. Many Fixed Income Securities are placed directly with (sold to) mutual
funds, insurance companies, investment companies, and other entities which will package
Yield is a figure that shows the return you get on a bond. The simplest version of yield is
calculated using the following formula: yield = coupon amount/price. When you buy a bond at
par, yield is equal to the interest rate. When the price changes, so does the yield.
Let's demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par
value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800,
then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100
on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200,
the yield shrinks to 8.33% ($100/$1,200).
Robin Kapoor, F-12 5
Fixed Income Securities IFS
Assignm
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Yield to Maturity
Of course, these matters are always more complicated in real life. When bond investors refer to
yield, they are usually referring to yield to maturity (YTM). YTM is a more advanced yield
calculation that shows the total return you will receive if you hold the bond to maturity. It equals
all the interest payments you will receive (and assumes that you will reinvest the interest
payment at the same rate as the current yield on the bond) plus any gain (if you purchased at a
discount) or loss (if you purchased at a premium).
Knowing how to calculate YTM isn't important right now. In fact, the calculation is rather
sophisticated and beyond the scope of this tutorial. The key point here is that YTM is more
accurate and enables you to compare bonds with different maturities and coupons.
Here's a commonly asked question: How can high yields and high prices both be good when
they can't happen at the same time? The answer depends on your point of view. If you are a bond
buyer, you want high yields. A buyer wants to pay $800 for the $1,000 bond, which gives the
bond a high yield of 12.5%. On the other hand, if you already own a bond, you've locked in your
interest rate, so you hope the price of the bond goes up. This way you can cash out by selling
your bond in the future
Robin Kapoor, F-12 6
Fixed Income Securities IFS
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