Personal Wealth Management

What is a fixed income security?

The key is in the very name of the asset class.

In general, investments in this asset class provide a known stream of fixed income over the life of the investment. At the end of the asset’s life, the original capital is repaid in full to the investor by the entity borrowing the funds.

Regardless of what the asset is called, if there is a continuous income stream, the investment is likely a fixed income security.

I would include all debt instruments in the fixed income asset class.

Because of the steady income stream, most preferred equity shares also fall within this category.

We will look at debt instruments first, then consider preferred shares afterwards.

It is common practice to group debt into three categories: money market, bonds, and debentures.

Today we will look at money market instruments.

Money Market Instruments

I consider almost all money market instruments to be Cash Equivalents within one’s investment portfolio. But as they are technically debt, and are influenced by many of the same variables as other debt issues, I will cover them here.

Money market instruments are part of the short term debt market used primarily by governments and large capitalized corporations with very strong credit ratings. By short term, less than one year until maturity.

Most money market instruments are issued at a discount and mature at face value. No actual interest is paid by the issuer. Rather the difference between the purchase price and the value at maturity is considered the interest.

In every jurisdiction I can think of, the amount earned between the purchase price and face value is treated as interest income, not a capital gain, for tax purposes.

However, if the money market instrument is traded in the secondary market prior to maturity, a portion of the return may possibly be treated as a capital gain or even capital loss.

Government Treasury Bills

For short term borrowings up to 1 year in duration, governments issue treasury bills (T-bills).

No interest is paid on the T-bills. They are issued at a discount to the face value equal to the required interest rate. Upon maturity, the face value is paid to the investor and the difference between the discount and par value is treated as interest income.

Bonds that do not pay interest, but are issued at deep discounts, are known as zero coupon bonds.

T-bills are guaranteed by the issuing government of a country. Because of the ongoing solvency of most countries, the shorter term T-bills are considered the safest of all investments. As such, the interest rate on T-bills is normally viewed as the risk-free rate of return.

Note that the fortunes of countries rise and fall. At any given time, a specific country’s T-bills may not be risk-free. For example, US T-bills are considered totally safe as I write this post. However, countries like Greece, Spain, and Portugal may not be seen as 100% secure right now.

Like any debt instrument, the interest rate offered by the issuer will depend on its credit rating. The worse the credit rating, the greater the interest rate that needs to be paid.

Corporate Money Market Instruments

Often corporations require short term funding to pay for current liabilities or finance short term assets such as trade receivables or inventory.

When corporations issue debt for periods up to one year, they have three options:

Commercial Paper

Unsecured debt issued by a company. Because the debt is not secured against any corporate assets, only companies with very strong credit ratings issue commercial paper.

Depending on the credit-worthiness of the issuer, these notes may be more or less risky. Interest rates offered on commercial paper will fluctuate between corporations based on their relative risk.

Acceptance Paper

Also know as Finance Paper or Asset-Backed Commercial Paper.

Secured debt that is issued by a finance or acceptance company. The issue is secured by specified assets such as receivables or inventory.

Assuming that the security is adequate to cover the issue, secured debt is normally less risky than unsecured debt.

For example, Debtcorp issues two classes of paper. One is secured against its trade receivables and inventory. The other is unsecured.

The non-secured debt will require a higher interest rate to be offered to reflect the higher risk of the instrument.

Banker’s Acceptances (BAs)

Debt issued by a non-financial corporation but where a bank guarantees its repayment.

Of the three corporate options, the least risky for investors. This is because there is two layers of protection with the involvement of the bank guarantee.

Because it is the least risky, all other things equal, BAs will offer the lowest returns.

Investing in Money Market Instruments

Most individual investors never directly invest in money market instruments. That is because the required minimum purchases are too high for many investors.

However, individual investors do purchase these instruments indirectly through money market funds (MMF). As you develop your investment portfolio, I would expect you to have a portion of your assets in MMF.

While each investor is unique, normally investing in MMF is preferable to holding your cash in savings or chequing accounts. That is because MMF offer higher returns than bank accounts and are highly liquid.

Depending on the financial institution, they usually offer better returns and greater liquidity than term deposits and Guaranteed Investment Certificates.

Next we will review bonds and debentures.