Understanding fixed income securities
The following frequently asked questions provide a brief introduction to fixed-income securities:
- What are fixed-income securities?
- Why invest in fixed-income securities?
- What are some examples of fixed-income securities?
What are fixed-income securities?
A fixed-income security is a debt instrument issued by a government, corporation or other entity to finance and expand their operations.
Fixed-income securities provide investors a return in the form of fixed periodic payments and eventual return of principal at maturity. The purchase of a bond, treasury bill, Guaranteed Investment Certificate (GIC), mortgage, preferred share or any other fixed-income product represents a loan by the investor to the issuer.
Why invest in fixed-income securities?
Fixed-income securities can be an important part of a well-diversified portfolio. For many investors, particularly retirees, fixed-income investments are a secure, low-risk way to generate a steady flow of income. As long as they are held to maturity, fixed-income securities will provide a guaranteed return on your investment, with payments known in advance.
What are some examples of fixed-income securities?
The following is a list of some common fixed-income securities:
A bond is an obligation or loan made by an investor to an issuer (e.g. a government or a company). In turn, the issuer promises to repay the principal (or face value) of the bond on a fixed maturity date and to make regularly scheduled interest payments (usually every six months). The major issuers of bonds are governments and corporations.
Savings bonds issued by the Canadian and various provincial governments are different from conventional bonds. Canada Savings Bonds (CSBs) typically pay a minimum guaranteed interest rate (there are also compound interest bonds available). A CSB carries no fees and is cashable at any time. The amount received for a CSB will never go below its face value if redeemed by the issuer, while the price received in the market for a conventional bond will depend on the level of interest rates at the time of sale. In addition, only residents of Canada (or of the province of issue) are eligible to purchase CSBs, and only up to a predetermined amount.
A GIC is a note issued by a trust company with a fixed yield and term. The Canada Deposit Insurance Corporation (CDIC) insures many GICs for interest and principal totaling up to $100,000. GICs are generally non-redeemable before the term is complete.
Treasury bills (T-bills) are the safest type of short-term debt instrument issued by a federal government. Ideal for investors seeking a 1- to 12- month investment period, T-bills are highly liquid and very secure.
Banker’s Acceptances (BAs) are short-term promissory notes issued by a corporation, bearing the unconditional guarantee (acceptance) of a major Chartered Bank. BAs offer yields superior to T-bills, and a higher quality and liquidity than most commercial paper issues.
A National Housing Act (NHA) MBS is an investment that combines the features of residential mortgages and Canadian government bonds. MBS investors receive monthly income consisting of a blend of principal and interest payments from a pool of mortgages.
Strip coupons and residuals are instruments purchased at a discount that mature at par (100). They grow over time and while any interest income is not payable until maturity, a nominal amount of interest is accrued each year and must be claimed as income by the purchaser for tax purposes. For example, a Canada strip coupon maturing on March 15, 2006 with a yield of 5.31% would be priced at 77.07 to mature at 100. The difference between the purchase price and 100 is treated as interest income. Strip coupons generally offer higher yields and can also fluctuate more than the price of a bond of similar terms and credit quality. All of the aforementioned features make strip coupons a popular choice for tax-sheltered accounts such as Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs).
A laddered portfolio is comprised of several bonds, each of which has a successively longer term to maturity. Each position in the portfolio is usually the same size as the next, with intervals between maturity dates roughly equal. A laddered portfolio helps spread reinvestment risk over the long term, helping to average out the effects of overall interest rate changes.