Fixed Rate bonds that are usually considered traditional ones are a good investment option for investors looking to park their money for a long term to gain interest at a fixed rate with no urgent cash requirement and a low-risk appetite. These also cater to the investors seeking to diversify their portfolios and are considered a good option.
To understand more about how fixed rate bonds work, their appeal to investors, risk and return on fixed rate bonds, and their advantages and disadvantages, let us start with understanding what fixed rate bonds are
What is a fixed rate bond?
A fixed rate bond, which is a debt instrument, that pays the same level of interest through its entire tenure. The interest rate on a bond is known as the coupon rate. The fixed coupon rate on the bond through the entire term makes it fall under fixed income securities. Investors that aim to earn a guaranteed interest for a given term can purchase these bonds. They also serve as a savings account if their coupon rates are pretty high.
Bondholders receive the entire principal along with interest upon maturity. The lock-in period for such bonds is usually one year and five years, where investors buy such bonds according to their financial planning.
In India, an investor can purchase a fixed rate bond in government bonds, most of which are fixed rate bonds, treasury bills, certificate of deposit (CD), treasury bonds, corporate bonds, etc.
How do they work?
Most fixed rate bonds require a minimum amount to be deposited by the investor when opening the account. It allows the investors to avail themselves of different terms according to their suitability, such as monthly or yearly interest. The bond term decides the interest rate, as long-term bonds usually yield higher interest rates than short-term bonds, thus creating more earnings for the investors.
The fixed interest rate, i.e., The coupon rate, is mentioned in the trust indenture when issuing the bond. It is payable on predetermined dates as stated in the bond until it matures. The return on investment of the bond can be predicted as the bondholder knows the exact interest they will earn for which tenure.
On the maturity of this bond, the investor can withdraw their money, transfer it to an access account or reinvest it into the same bond. Investors can make their decisions and choose any of these options depending on their portfolio needs and bond terms.
To understand this better, let’s take an example:
An investor purchased a ten-year fixed rate bond of a 9% coupon rate on 10th March 2010. This bond pays fixed coupons on a semi-annual basis on the bond’s face value in March and September every ten years. The maturity date of this bond is 10th March 2020.
Advantages of Fixed Rate Bonds
These pointers tell us about the pros of fixed rate bonds:
- When it comes to fixed rate bonds, the investors know the interest they will receive in the end. Stability is a significant advantage of these bonds.
- Fixed Rate Bonds are less risky as compared to other saving instruments. They offer better returns as compared to other saving options. In case of sudden volatility in the market, such as an economic recession or pandemic, these bonds are a secure financial instrument.
- Government bonds issued by the state or central governments have high safety and do not usually default as trusted organizations issue them. The same is true for corporate bonds as well. However, government-issued bonds are still a safer option than corporate-issued bonds. The creditworthiness of the bonds is also evident as they are meticulously rated by the credit rating agencies such as CRISIL, CARE, etc.
- Certain investors prefer these bonds as they give them the freedom to select a suitable tenure and amount that aligns with their financial goals.
It is also essential to consider the few disadvantages of fixed rate bonds to make investment plans accordingly.
Drawbacks of Fixed Rate Bonds
These pointers tell us about the cons of fixed rate bonds:
– Premature withdrawal of bonds can lead to penalties for investors.
– Thefixed rate bonds investment is suitable to the investors only if they decide to adhere to the set lock-in period.
– Due to the year-on-year rise of inflation, the higher the bond term, the more it runs the risk of reducing bond value. Such inflationary forces can affect the interest rate of return and keep the investors from gaining attractive returns.
– There is default risk by the bond issuer due to liquidation or bankruptcy, leading to loss of interest and the principal amount of the investor. Investors should select a trustworthy bond issuer who offers deposit protection to avoid such risks.
Fixed-Rate bonds offer the investors the excellent option to diversify their investment portfolio and reduce the exposure and risk to investing in only a few particular assets. Buying fixed rate bonds such as government securities through government securities mutual funds is a common route taken by retail investors. Another way to avail government securities is through bidding directly bond auctions on the E-Kuber platform of the Reserve Bank of India.
However, India has a vast number of investors in all investment avenues. One should thoroughly research, understand and then avail the option of fixed rate bonds. It should be based on factual data and figures to align with the risk appetite and long-term financial goals to get the most returns for the investors.