What Are Fixed-Income Securities?

7.2 What Are Fixed-Income Securities?

It’s pretty amazing how sometimes an investment can pay you like clockwork—almost like having a little machine that spits out income every few months. That’s exactly how I first felt when I discovered fixed-income securities, and I remember thinking, “Wow, this is so different from the ups and downs of the stock market!” Well, let’s explore that world together in a bit more detail (but I’ll keep it as down-to-earth as possible).

Fixed-income securities are debt instruments, meaning they’re essentially “IOUs” from the entity (government, corporation, or other organization) issuing them. In return for your cash, the issuer promises to pay interest at specified intervals and then return the principal (the original amount lent) on a set maturity date. These securities often come with a prearranged interest rate, sometimes called the coupon rate, which allows investors to predict the income they’ll receive. Because of this stability, they’re widely used to manage risk, stabilize portfolios, and maintain steady cash flows.

Below, we’ll examine what makes fixed-income securities tick, the risks you should keep an eye on, and how you can apply this knowledge when building or managing a portfolio—especially if you’re advising clients as a mutual fund representative.

Key Highlights of Fixed-Income Securities

Before diving deeper, let’s clarify the key points:

• Predetermined Income: The very name “fixed-income” suggests predictable coupon (interest) payments.
• Repayment of Principal: On maturity, you get back the original face value (also called par value).
• Issuer Variety: Governments, corporations, and financial institutions can all issue fixed-income securities.
• Credit Quality Determines Yield: An issuer with a higher credit risk typically offers a higher interest rate to lure investors who are taking on more risk.
• Sensitivity to Interest Rates: As market interest rates change, the prices of outstanding fixed-income securities fluctuate (inversely).
• Role in Portfolios: Fixed-income holdings help reduce overall volatility and provide stable income streams.

A Quick Glossary

Sometimes, the terminology around bonds and other debt instruments can trip people up. Let’s do a quick run-through of very popular terms:

• Coupon Rate: The annual interest rate (expressed as a percentage of face value) that the issuer pays to bondholders.
• Face Value (Par Value): The principal amount the issuer agrees to pay back at maturity.
• Maturity Date: The date when the principal (face value) is repaid to investors, and the bond effectively expires.
• Yield to Maturity (YTM): A more holistic measure of a bond’s annualized return, assuming you hold the bond until maturity and reinvest interest payments.
• Interest Rate Risk: The chance that bond prices fall when new market interest rates rise, or vice versa.
• Default Risk: The possibility that the issuer can’t pay the interest or repay the principal as promised.
• Liquidity Risk: You might find it difficult or costly to sell your fixed-income security quickly if there aren’t enough buyers in the market.
• GIC (Guaranteed Investment Certificate): A popular Canadian instrument that guarantees your initial principal and typically a fixed rate of interest, for a set term.

Types of Fixed-Income Securities

There’s no shortage of choices when it comes to fixed-income. Each type carries its own flavor of risk, reward, and structure, but they mostly share the same unifying idea: They pay interest and return principal.

Treasury Bills (T-Bills)

T-bills are short-term government debt—kind of like an IOU that matures in a year or less. They don’t pay an actual “coupon” per se. Instead, you buy them at a discount, and when they mature, you get the full face value. The difference is your income. For example, if a $1,000 T-bill is purchased for $980, you earn $20 when it matures a few months later. T-bills are considered among the safest investments, especially when issued by the Government of Canada, because the likelihood of default is extremely low. Because of their safety, yields are usually modest.

Government Bonds

This is where you’ll find your Canada Savings Bonds (though they’re no longer issued, historically they were a classic example), Government of Canada bonds, and provincial bonds. Government bonds usually pay a set coupon and have a maturity date that can range from one year to 30 years or more. Longer maturity generally means higher interest rate risk: if interest rates rise during that time, the price of your bond tends to go down.

Corporate Bonds

Corporate bonds are like government bonds but issued by companies. Some corporations have stellar credit records—think big banks or stable utilities—while others might have more questionable credit quality. The market lumps corporate bonds into “investment grade” and “high-yield” categories. Investment grade implies relatively strong credit quality, whereas high-yield indicates higher default risk and thus typically pays a juicier coupon. Keep in mind that the higher the coupon, the more risk the lender (you, the bondholder) is taking, because there’s a bigger chance the company might face financial trouble down the line.

Guaranteed Investment Certificates (GICs)

GICs are more of a bank product but are still considered a fixed-income vehicle. GICs guarantee the principal and an agreed-upon interest rate for a specified term, typically ranging from 30 days to five years or longer. They’re often used by conservative investors seeking stability, though you generally can’t redeem them before maturity without facing penalties or restrictions.

How Fixed-Income Securities Work: A Simplified Diagram

To visualize the timeline of a fixed-income security, here’s a simple Mermaid diagram:

    flowchart LR
	    A["Issuer <br/> (e.g., Government, Corporation)"] --> B["Underwriter <br/> (Raises Capital)"]
	    B --> C["Investors <br/>(Receive Coupons & Principal)"]
	    C -->|Pays cash to issuer<br/>through underwriter| B

• The issuer (A) creates a bond (or other debt instrument).
• An underwriter (B) may help structure and sell that bond to investors.
• Investors (C) provide the cash to the issuer through the underwriter and, in return, receive periodic interest plus the return of principal at maturity.

Key Risks for Fixed-Income Investors

Even though fixed-income instruments are typically less volatile than stocks, they come with their own set of risks.

• Interest Rate Risk: If you buy a 10-year government bond and interest rates suddenly leap upward, new bonds being issued might pay higher coupons. That means your older bond paying a lower interest rate is less appealing unless its price drops.
• Inflation Risk: If inflation rises, it can erode the purchasing power of your interest payments. Additionally, if inflation expectations rise, market interest rates tend to rise too, which can drive bond prices down.
• Default Risk: A corporate issuer could run into financial trouble, missing interest or principal payments. Government bonds are typically seen as safer, though no issuer is 100% immune to financial pressures.
• Liquidity Risk: Not all bonds trade frequently on the market. If it’s obscure or has fewer buyers, you might have to accept a worse price to sell quickly.

Credit Quality and Yield

Remember hearing the phrase, “No risk, no reward”? Bonds—and other debt instruments—perfectly illustrate that principle. If the issuer’s credit rating is rock-solid (like the Government of Canada), yields are usually lower. If the issuer’s credit rating is lower, or if it’s an emerging market government, the yields tend to be higher to compensate for default risk.

Credit rating agencies like Standard & Poor’s, Moody’s, or DBRS Morningstar assess issuers’ creditworthiness. Their ratings help investors weigh risk versus reward. A rating of AAA or AA is considered strong while anything below BBB- tiptoes into speculative (high-yield) territory. Naturally, the higher the perceived risk, the more the issuer must pay you in coupon interest to entice you.

Relationship Between Price and Yield

Maybe you’ve heard the phrase “the bond seesaw.” In practice, bond prices move inversely to interest rates. Let’s do a quick example: Suppose you buy a bond with a 3% coupon. If market interest rates jump to 5%, your 3% coupon suddenly looks less attractive, so the market price of your bond will probably drop until it effectively yields something closer to 5%. Conversely, if rates fall, your bond’s coupon becomes more appealing, so its value goes up.

This dynamic can be expressed using a simplified yield to maturity formula:

Where:
• \( C \) = Annual coupon payment
• \( F \) = Face (par) value
• \( P \) = Current market price
• \( n \) = Number of years to maturity

Even if this looks a bit technical, the gist is: as \( P \) changes, your return (YTM) also changes.

Short-Term vs. Long-Term Fixed-Income

Short-term fixed-income instruments—like T-bills or GICs maturing within a year—often help investors park idle cash or maintain emergency funds, matching short time horizons. These short-term products are less sensitive to interest rate movements. Meanwhile, longer-term bonds often pay higher coupons, but can experience bigger price swings when interest rates shift.

As a mutual fund sales representative, you might choose short-term bonds or money market funds for clients who need quick access to their cash or have relatively low risk tolerance. For clients seeking to lock in higher yields and who can handle some market volatility, longer-term bonds might be more fitting.

Why Mutual Fund Representatives Use Fixed-Income Securities

Fixed-income securities are indispensable in portfolio construction. They help smooth out the unpredictable nature of equity returns and can provide a steady stream of income, especially useful for retirees or clients with specific income needs.

• Diversification Benefits: When equity markets plunge, safer debt securities (like government bonds) often hold their value better, reducing overall portfolio volatility.
• Income Generation: Regular coupon or interest payments can supplement your client’s cash flow.
• Capital Preservation: Some fixed-income investments, like GICs or high-rated government bonds, are particularly well-suited for protecting principal.

Additionally, fixed-income mutual funds or ETFs bundle many bonds (often hundreds or even thousands) together, helping to lower default risk via diversification. When you think about a single corporate bond, if that issuer defaults, you stand to lose out. But in a diversified bond fund, the impact of one default is smaller (though by no means inconsequential).

Real-World Example: Navigating Changing Rates

I once had a friend, let’s call her Jasmine, who swore she’d never own anything but GICs. She loved the simplicity of locking in an interest rate and not worrying about price fluctuations. But then, as interest rates started dropping, she saw the return on GIC renewals shrink. Meanwhile, those who owned longer-term government bonds were suddenly singing with delight because their fixed coupons were higher than new-lower market rates, and the prices of those older bonds were going up. This scenario shows how a certain fixed-income strategy can shine under particular market conditions and be less ideal in others.

That doesn’t mean GICs are bad or that long-term bonds are always the way to go. It simply highlights how each product fits a specific need, which in turn underscores the importance of understanding client profiles in terms of risk tolerance, interest rate expectations, and horizon.

Potential Pitfalls and Challenges

• Overconcentration: If you throw a large chunk of your portfolio into a single corporate issuer’s bonds, you’re exposed to that company’s default risk. Even well-known brands can suffer sudden challenges.
• Chasing Yield: Sometimes, people chase the highest interest rates without properly assessing credit risk. Before you know it, they might be stuck with bonds from an issuer that’s teetering on the edge of default.
• Underestimating Inflation: If inflation levels are higher than the nominal coupon, the real return (inflation-adjusted) can be disappointing.
• Locked-In Rates: Buying a GIC locks in a fixed rate, which can be great if rates dip afterward, but not so great if rates climb.

Best Practices for Advisors

• Conduct Thorough KYC and Suitability: As outlined in Chapter 4: Getting to Know the Client, you have to gauge your client’s goals, risk tolerance, and time horizon to recommend suitable fixed-income solutions.
• Laddering Strategy: Consider building a “bond ladder,” where you purchase bonds or GICs that mature at different intervals. This helps reduce interest rate risk and provides some flexibility.
• Review Regularly: Don’t just set it and forget it. Revisit interest rates, inflation expectations, and issuer credit quality to see if rebalancing is warranted.
• Watch Regulatory Requirements: Under CIRO’s rules (CIRO is Canada’s self-regulatory organization overseeing investment dealers and mutual fund dealers), there may be specific compliance and registration requirements when dealing in certain fixed-income products.

Tools and Resources

• Bank of Canada’s Yield Curve: Visit the Bank of Canada website (https://www.bankofcanada.ca/rates/interest-rates/canadian-interest-rates/) for daily yield information across various maturities.
• CIRO Rulebooks: Since MFDA and IIROC merged into CIRO, consult the CIRO resources (https://www.ciro.ca) for the latest regulatory updates on selling fixed-income products.
• “Fixed Income Securities” by Frank J. Fabozzi: An in-depth resource for those wanting a serious deep dive into valuations, hedging strategies, and advanced bond mechanics.

Practical Takeaways

• Fixed-income securities serve as the foundation for stable income in a portfolio alongside equity and other assets.
• Always remember that “fixed income” doesn’t mean “no risk.” Price fluctuations, interest rates, inflation, and creditworthiness matter immensely.
• Achieving the right balance of short-term vs. long-term instruments is key, depending on your client’s needs and market conditions.

If you’re feeling ready, Chapter 7.3 next discusses The Fundamentals of Bond Pricing and Properties, which will build on what we’ve covered here and explore how bond pricing actually works in more detail (like how a bond’s duration can tell you just how sensitive it is to changes in interest rates).

Keep learning and don’t be afraid to ask questions along the way. The more you understand fixed-income securities, the better equipped you’ll be to guide clients toward strategies that suit their individual goals and risk profiles.

Fixed-Income Securities Mastery Quiz