(The following is an extract from our book - A Clear Direction - Your Guide to Being a Successful CEO of Your Life)

Fixed interest securities are traditionally loans made by investors to governments or companies.  These types of securities represent a loan to the issuer usually in return for periodic fixed interest payments.  These payments continue until the security is redeemed by the issuer at maturity or earlier if called.  Under law, holders of debt have the first call on the income and assets of a company.  Specifically interest payments have priority over any dividend payments to shareholders.  As a consequence such investments are generally viewed as less risky than equity investments because holders must be paid first before any returns are paid to shareholders.  However, fixed interest securities are not risk-free and may carry many different kinds of risk.  As a result these investments are riskier than holding cash.

We would therefore expect, over time, that the expected returns on fixed interest securities would be less than returns to owners of shares in a company but more than simply leaving cash in the bank.

Use of these type of securities sounds simple.  However there is much more to the story.

Let's first start with an overview of the basic principles surrounding fixed interest investments.

Basic Principles

As mentioned previously, fixed interest securities are loans issued by a company or government usually in return for periodic fixed interest payments.  Payments to holders of fixed interest securities continue until the security is redeemed by the issuer at a pre-determined maturity date or earlier if called by the issuer.  Holders of these securities face a number of major risks that need to be carefully considered. Particularly our focus will be on:

Ø       Default risk

Ø       Interest rate and maturity risk

The default risk of a particular fixed interest security issue is directly related to the riskiness of the venture for which the funds are being raised.  If the issuer does not have the cash flow to make the interest payments they are at risk of defaulting.  The possible default risk is clearly measured by a range of rating agencies such as Moody's or Standard and Poor's (S&P).  These agencies measure the credit worthiness of the issuers of the bonds and each issue of credit.  The agencies clearly identify the perceived ability of the issuer to honour the interest payments and pay back the value of the bond at maturity.  These ratings, therefore, directly affect the necessary reward that the issuer must provide to the holder of the bond, that being the interest rate.  The greater the risk, the greater the expected return to holders of the bonds and therefore the higher the level of interest that needs to be offered to attract people to hold these bonds.

To give an example, the highest possible rating by S&P for an issue of fixed interest securities is AAA.  The ratings then decrease to AA, A, BBB, BB, B, CCC, CC, C and D with D indicating there has been a payment default.  Therefore you would expect to receive a smaller interest rate for a fixed interest security issue with an AAA rating compared to one with a BBB rating, all other things being equal.

A second major risk to be considered by prospective holders of fixed income securities is that of interest rate risk.   We all know that interest rates fluctuate over time.  On the first Tuesday of every month the board of the Reserve Bank of Australia meets to determine the cash rate target.  We will not go in to detail at this time but in simple terms this decision affects all other interest rate products throughout the country, fixed income securities included.  The price of fixed income securities move in the opposite direction of these rates, i.e. when rates rise, the price of bonds fall and vice versa.  For example, consider a newly issued 15 year government bond with an 8 percent coupon.  If over the next year interest rates rise by 3 percent, new 15 year government bonds will be offered with an 11 percent coupon, all other factors remaining equal.  Therefore the old 8 percent bonds will be worth less than the new bonds.  This in turn will force the price of the old bonds down.  As the length of maturity increases, the likelihood of such interest rates movements becomes more likely and creates more volatility.  This has the effect of making these types of securities much riskier.

Therefore when considering the use of fixed income securities within a portfolio, clear consideration needs to be given to the length of time until maturity.  Bonds have different lengths of time before maturity.  Bonds with a maturity date of less than five years are considered short term, between five and twelve years are intermediate and maturities longer than twelve years are long term.

From our previous discussion it would appear that the longer an investor holds a particular fixed income security the greater the risk for doing so.  We next need to ask whether holders of these longer term bonds are appropriately rewarded for holding this extra risk.  Eugene Fama of the University of Chicago studied the rates of return of long-term bonds in the US from 1964 to 1997.  He found that bonds with maturities beyond 5 years did not offer sufficient reward for their higher risk.

Considering the types of risk for fixed interest securities, we start seeing that as default and maturity risks rise the fixed interest security starts to behave more like equity.  However investors are not being adequately compensated for holding this greater risk and would be better advised to invest their money in other asset classes such as shares.

Why then would or should people hold long term fixed interest securities?

The major investors in this market are corporate pension plans and life insurance companies.  They hold these securities to help fund long-term obligations and are not concerned with volatility of the value of the security or the effects of inflation because their future payments are fixed in maturity date and amount.

The Role of fixed interest in a portfolio

There is a place for fixed interest securities in an investment portfolio.  Fixed interest securities play an important part of a comprehensive portfolio as they provide less volatility compared to equity investments.  They also pay higher rates of returns than holding cash in a bank.  Holding these securities within a portfolio provides greater stability and lowers the risk of the overall portfolio.  This can be achieved by using short-term fixed income securities with a high rating, say of AA or AAA standard.  Fixed interest securities should not be used to obtain high returns via lowly rated issues and / or issues with long maturity dates.

Diversification

The pricing of fixed interest securities is efficient enough that so that if one company is offering AA rated bonds with a 5 year term and 7% yield, then another company with an AA rating will be offering almost exactly the same yield.

So, the expected return from holding either companies bonds will be 7%.  There is no chance that, if you hold the bonds to maturity, you will get a higher return than the 7%.  However you are still exposed to the risk that if either company fails, which is still a small possibility even with AA rated bonds, you will lose your investment.

Clearly holding as many AA rated bonds as possible that offer a 7% return does not reduce your expected return.  However it does decrease the extent to which you are exposed to one company defaulting on their bond repayments.  There can be no question that with fixed interest securities diversification is your friend.