When it comes to investments, there are many options available to investors who seek to grow their wealth. Fixed rate bonds are one such option that offer a fixed rate of return over a set period. In this article, we explore what fixed rate bonds are, how they work, their advantages and disadvantages, and the difference between fixed rate bonds and floating rate bonds.
Fixed rate bond definition and interest rate risks
A fixed rate bond, as the name suggests, is a bond that offers a fixed rate of interest to the bondholders throughout the life of the bond. It is a type of debt security whereby investors lend money to government entities or corporations for a specified period. In return, they receive interest payments on their principal investment at a fixed rate.
The interest rates on fixed rate bonds do not change regardless of the market scenarios. This makes fixed rate bonds a less risky investment option for those who prefer a steady and predictable income flow from their investments. However, the fixed rate of the bond may be lower compared to a floating rate bond.
One of the risks involved with fixed rate bonds is the interest rate risk. Interest rate risk refers to the chance that the interest rates in the market may rise, leading to a decline in the bond’s value. If the investor wants to sell the bond when interest rates are higher, they may have to do so at a lower price. Another risk involved with fixed rate bonds is the credit risk, which refers to the issuer's ability to pay back the bondholders the principal and interest at maturity.
How do fixed rate bonds work?
When a company or government issues a fixed rate bond, it outlines the interest payments the bondholders will receive throughout the bond’s term. The bondholder will receive these payments at a fixed interest rate of the bond, which could be a higher or lower rate depending on the issuer's creditworthiness and market conditions.
Fixed rate bonds can have different maturity periods. Investors receive their principal investment back upon the bond's maturity. However, investors who want to cash out before maturity might incur a loss or a gain depending on the bond’s current market prices.
Advantages & disadvantages of fixed rate bonds
Like most investment options, fixed rate bonds have their share of advantages and disadvantages.
Advantages:
- Predictable and steady income: One of the most significant benefits of investing in fixed rate bonds is the predictability and steadiness of the income received. This makes fixed rate bonds an excellent investment option for those seeking a stable income flow.
- Low-risk investment option: Fixed rate bonds offer a lower risk option compared to stocks, making them a safer investment choice. Investors are assured of a fixed return and risk low to no loss of their investment principal.
- Guaranteed return on investment: Fixed rate bonds offer a guaranteed return on investment, which makes them an attractive choice for those seeking to invest in a stable and secure investment vehicle.
Disadvantages:
- Lower potential returns: Fixed rate bonds offer lower returns compared to other investment options like stocks and mutual funds. This is because they are generally safer investment instruments than stocks.
- Changes in Opportunity cost: Investment returns don't keep up with inflation over time. Therefore, there is always the risk that fixed rate bonds' return may not be high enough to keep up with the changing economy's inflation rates.
- Interest rate risk: Interest rates in the market can change, and this can affect the bond's return. This means if the market interest rates rise, it could impact the fixed rate bond's value.
Difference between fixed rate bonds and floating rate bonds
Floating rate bonds are a type of bond that offers a variable interest rate based on a benchmark interest rate, such as a government's treasury bill rate. This means investors receive interest payments that can fluctuate based on market changes in the benchmark interest rate.
The interest rate risk attached to fixed rate bonds and floating rate bonds are inversely proportional. This means when the market interest rates are estimated to increase, a floating rate bond will perform better than a fixed-rate bond, as the investor's return also increases.
Conclusion
Fixed rate bonds can provide a predictable and safe option for investment, especially for those seeking a guaranteed flow of income. While there is the potential for consistent returns, investors should consider the various risks and advantages before investing. The fixed rate bond remains an ideal investment instrument for risk-averse investors seeking financial security.
If you're considering taking the first step towards building a diversified investment portfolio, now is the perfect time to explore the world of bonds. Bajaj Finserv can be your partner on this exciting journey. Start your bond journey today for a secure financial future.
