Though fixed-rate bonds are often categorised as traditional ones, they have their share of attractions. Investors who have no immediate requirement of extra cash or are looking for means to generate steady yet assured returns on their current savings find this bond suitable.
To further assess its pros and cons, the following is a look at this debt instrument in detail.
What is Fixed Rate Bond?
It can be best described as a debt instrument that yields the same level of interest through its entire term. This is why it is also known as fixed-income securities. The best fixed-rate bonds serve as a type of savings account that offers higher coupon rates.
Typically, they are contrasted with variable or floating rate bonds. The fixed-rate is mentioned in the trust indenture during issuance and has to be paid on pre-fixed dates until the debt instrument matures.
Investors who intend to generate a guaranteed interest rate for a given term may find this bond suitable. It also extends robust protection to the deposited amount. Bondholders receive the initial principal amount along with interest when the bonds mature. Notably, the long-term bonds yield higher interest rates, as compared to those which come with a short term. Typically, the lock-in period ranges between 1 year and 5 years.
How do Fixed Rate Bonds Work?
This particular debt instrument can be availed at different terms. Most fixed-rate bonds make it mandatory for investors to deposit a minimum amount to open their account.
Like discussed, a bond with a longer-term attracts a higher interest rate and thus generates more earnings. Generally, fixed-rate bond issuers provide investors with the option to receive interest either on a monthly or yearly basis.
When compared to most savings accounts, this particular debt instrument requires investors to deposit in a lump sum and usually at the time of opening the account.
On maturity, investors can either withdraw the money or transfer it to an access account. They may also consider reinvesting the same into another account. Notably, the decision to choose any of these options may depend on the bond issuer or on the terms accompanying the debt instrument.
Here is an example to understand the pay-out of fixed-rate bonds better –
A fixed-rate bond was issued on 22nd April in 2008 for a term of 10 years with its maturity date being 22nd April 2018. The coupon rate for it was 8.24%, and it was paid out on a half-yearly basis on the face value in October and April of every year.
Most of the government bonds are issued as fixed-rate bonds in India. Some common fixed-rate bonds examples include – treasury notes, treasury bonds, etc.
Advantages of Fixed Rate Bonds
These pointers highlight the most common benefits of fixed-rate bonds in India.
- One of the top benefits of a fixed-rate bond is that investors are aware of the exact amount of interest they will earn on their deposit and for how long.
- These bonds offer better interest rates when compared to protected savings tools.
- They serve as a fruitful avenue for parking money as per need and requirements.
- Investors have the freedom to have such a suitable tenure that matches their financial goal.
Collectively, these enable investors to ascertain the exact amount of money they will receive on maturity. In turn, it helps to develop a better financial plan and align the same to achieve investment goals. Regardless, there are a few drawbacks of this debt instrument that one must be aware of to streamline investment accordingly.
Disadvantages of Fixed Rate Bonds
Some of the prominent limitations of fixed-rate bonds are given below –
- Investors who decide to withdraw their bonds prematurely are subject to penalties.
- These bonds prove to be a suitable savings option only if investors decide to stick to the rigid lock-in period.
- Investors are subject to interest rate risk and may lose out on generating attractive returns on them in case the inflationary rates undergo a hike.
- Often bonds with a longer-term accompany the risk of eroding bond value. Such a risk becomes inevitable in a market where the inflationary rate keeps increasing each year.
- Almost all types of financial institutions offer this bond. Individuals must always select a fixed-rate bond issuer who extends deposit protection or is at least trustworthy. It will help minimise the risk of losing one’s deposited money in case of bankruptcy or liquidation of the financier.
Difference between Fixed Rate Bonds and Floating Rate Bonds
In order to compare both bonds, individuals must make it a point to weigh the pros and cons of each option.
This table below offers a brief idea about the fundamental distinctions between the two types of bonds –
|Fixed-rate bonds||Floating rate bonds|
|These bonds are known as fixed-rate bonds as their rates remain fixed throughout the investment term.||These bonds are known as floating rate bonds as their rates tend to fluctuate throughout the investment term.|
|A fixed-rate bond is susceptible to interest rate risk.||A floating-rate bond does not expose investors’ deposit to interest rate risk.|
|Investors can easily ascertain the final amount they would receive on maturity.||Investors find it challenging to ascertain the final amount they would receive on maturity.|
|They help to craft a financial plan and further help to align financial goals accordingly.||It is not easy to build a reliable financial plan as the returns may or may not align with a specific financial goal.|
It must be noted that the decision to choose fixed-rate bonds should be based more on facts and features and less on personal preference. Furthermore, one must factor in their financial goals and ability to weather interest risk before speculating about returns.