Fixed-income security is an investment product that provides regular returns to investors in terms of periodic interest pay-outs. Such interest pay-outs are made at the interest rates fixed at the time of investing. While the traditional form of fixed income securities includes bank deposits, the evolved version of fixed income securities includes bonds, debentures, etc. 

Key Terms one should know while investing in fixed income securities

Here are some of the critical terms one should know while investing in fixed income securities:

1. Face Value – It refers to the principal value of the debt security. For example, a bond may be issued with a face value of Rs. 1,000. 

2. Coupon Rate – It refers to the contractual interest rate agreed with the issuer at the time of investing. The interest pay-out is calculated as the product of face value and coupon rate. 

3. Yield to Maturity (YTM) – It refers to the implied returns given by the fixed-income security considering the current market price and future cash flows. When the market price is equal to the face value on the interest payment date, the yield is equal to the coupon rate. 

However, the market value may not always be equal to the face value due to the interest rate changes and changes in the credit profile of the issuer. As such, the yield will also be different than the coupon rate. Yield is inversely proportional to the market price of the security. 

4. Credit Rating – It gauges the creditworthiness of the issuer entity. Specified Credit Rating Agencies are authorised to issue ratings for the issuer entities, wherein AAA refers to the lowest risk of default denoting the highest safety.

The credit rating reflects the credit risk of the issuer entity. Markets tend to price the coupon rate for any entity as the interest rate for risk-free government security of similar tenor plus the credit spread as applicable for such issuer entity, generally depending upon the credit rating.

How Fixed-Income Securities generate returns for the investors?

1. Accrual Income

This is the primary source of income for investors in fixed income securities. While the investors may receive interest pay-outs after specified periods, they may be entitled to the interest income with each passing day. Such interest accrual gets factored in the market price of fixed income securities as well.

2. Changes in Interest Rates 

Since the interest rate is fixed at the time of investing, the subsequent changes in market interest rates impact the valuation of such security. When the interest rates decrease in the markets, the existing securities issued at higher coupon rates become more attractive. 

These securities may quote at a premium to the face value since investors benefit from higher coupon payments than the prevailing interest rates. The extent to which such interest rate movements impact the security valuation depends on the security's remaining tenor. This is because it directly affects the benefits the investors will get through higher coupon payments. 

3. Changes in the Credit Profile 

The market valuation may also get impacted by the changes in the credit profile of the issuer entity. When the credit rating of an issuer is upgraded, the resultant credit spreads also decrease, resulting in the lower interest rates for the securities issued. 

Similarly, when the credit rating is downgraded, the investors expect a higher risk premium from the issuer entity, leading to an increase in market interest rates for such issuer. As such, the valuation of such fixed income securities may be impacted by the changes in the market yields for such entities.

Benefits of Fixed Income Securities

With fixed income securities, the investors are assured of fixed returns with periodic pay-outs. If the investor holds the securities until maturity, the coupon rate reflects the absolute returns earned by them. The regular pay-outs tend to provide stable and reasonable returns to the investors, also mitigating the investors from market volatility.