Fixed Rate Bond - Meaning And Interest Rates
Introduction
Diversification is critical in investing. Indian investors have, to date, preferred traditional low-yielding avenues such as gold and bank FDs for diversified investing, as equity sounds volatile and riskier.
An asset class gaining traction in India is fixed-rate bonds. These bonds offer higher returns than bank FDs and carry a lower risk than equities. As the name suggests, they have fixed coupon (interest) rates and a predetermined maturity.
Let us explore fixed-rate bonds, their working, advantages and disadvantages, and suitability to the investors.
What Is A Fixed-Rate Bond?
A fixed-rate bond allows you to invest a lump sum amount for a fixed period and a predetermined coupon rate. This enables you to get a stable fixed income at regular intervals. Fixed-rate bonds are issued by corporates, governments, and municipalities.
Generally, bonds with longer investment durations yield higher returns than those with shorter durations with minimum investment periods typically ranging from one to five years.
How Do Fixed Rate Bonds Work?
The aim of issuing fixed-income securities is to raise funds from the public as a loan and offer interest in exchange. Corporates may use the amount for their business operational and expansion needs, while the government uses it for development.
They offer a fixed interest rate for a period known as tenure. Investors who purchase these bonds receive regular interest payments, typically monthly, quarterly, semi-annually, or annually, and the principal amount is returned upon maturity. They are usually illiquid; however, if you wish to redeem your investment before it matures, it may lead to penalties and reduced returns.
The interest rate is determined at the time of issuance and remains unchanged throughout the tenure. Fixed-rate bonds provide a predictable income stream and are considered a safe investment option. However, they may not offer protection against inflation, as the interest rate does not adjust to changing market conditions.
Advantages Of Fixed Rate Bonds
- Steady Returns: Fixed-rate bonds offer fixed income to the investor, which is ideal for conservative investors. The interest remains consistent throughout the investment tenure and is paid at fixed intervals, such as quarterly, six months, or yearly, depending on the bond.
- Low-Risk Investment: Unlike equity, fixed-rate bonds have lower risk as their rates do not fluctuate with market conditions. Furthermore, risk varies with the issuer's creditworthiness. Investment-grade bonds are usually safer instruments.
- Diversification: Fixed-rate bonds are a great way to diversify your portfolio due to their non-market-linked nature. They offer a stable return and can shield against market volatility.
Disadvantages Of Fixed Rate Bonds
- Illiquid: Once you invest in fixed-rate bonds, you cannot withdraw the amount anytime you want until maturity.
- Interest Rate Risk: The market interest rate tends to change, which may impact the bond’s return. A rise in market interest rates may hamper the value of fixed-rate bonds.
- Penalties: Fixed-rate bonds have a fixed maturity period, but if the investor chooses to take out money before the maturity period, they may have to bear penalties.
Who Should Invest In Fixed Rate Bonds?
1. Conservative Investors
Fixed-rate bonds are suitable for investors seeking stable returns with a low-risk tolerance, unlike equities, which may be volatile.
2. Passive Investors
Fixed-rate bonds typically have a lock-in period of one to five years. Investors who want to lock their funds into low-risk passive instruments can invest in fixed-rate bonds.
3. Goal-Based Investors
If you have set a goal with your investment, such as paying a downpayment, saving for your daughter’s wedding, etc., investing in fixed-rate bonds is a good choice as they provide interest and give back the principal amount on maturity.
4. Retirement Planners
If you are close to your retirement or planning, investing in fixed-rate bonds is a good option as it will give you regular interest, which you can use as your pension to some extent, and also get the principal when your bond matures.
5. Diversification Seekers
Fixed-rate bonds offer much-needed portfolio diversification, offering non-market-linked predictable returns and lower risk than stocks.
Difference Between Fixed Rate Bonds And Floating Rate Bonds
Basis | Fixed-rate Bonds | Floating-rate Bonds |
Meaning | Fixed-rate bonds yield fixed interest rates regularly until they mature. | These are called floating-rate bonds, whose interest rates change depending on the market condition. |
Predictable | They offer predictable income. | The interest rate depends upon the market conditions. Hence, their returns are not predictable. |
Returns | Investors are sure of the amount that they will get upon maturity. | The amount is dependent on the market conditions. |
Conclusion
While fixed-rate bonds offer stability in terms of returns, it is crucial to research before making any investment decisions. Consider your risk profile, assess potential returns, match them with your financial goals, and make a better investment decision.
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Frequently Asked Questions (FAQs) On Fixed-Rate Bonds
1. What are fixed-rate bonds and interest rates?
Fixed-rate bonds are debt instruments that guarantee a fixed income throughout their tenure. Typically, the interest rate is around 10-14%.
2. Is the bond rate the same as the interest rate?
No. Most bonds and interest rates have an inverse relationship. Bond prices typically go down when rates go up, and when interest rates decline, bond prices usually rise.
3. Why are bonds better than FD?
Bonds are considered better than FDs because they offer higher returns. While bank FDs offer 5-6% interest per annum, fixed-rate bonds provide between 9-14% interest per annum.
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