What Is a Fixed Rate Bond?
A fixed rate bond is a bond that pays the same level of interest over its entire term. An investor who wants to earn a guaranteed interest rate for a specified term could purchase a fixed rate bond in the form of a Treasury, corporate bond, municipal bond, or certificate of deposit (CD). Because of their constant and level interest rate, these are known broadly as fixed-income securities.
Fixed rate bonds can be contrasted with floating or variable rate bonds.
Key Takeaways
- A fixed-rate bond is a debt instrument with a level interest rate over its entire term, with regular interest payments known as coupons.
- Upon maturity of the bond, holders will receive back the initial principal amount in addition to the interest paid.
- Typically, longer-term fixed-rate bonds pay higher interest rates that short-term ones.
Understanding Fixed Rate Bonds
A fixed rate bond is a long-term debt instrument that pays a fixed coupon rate for the duration of the bond. The fixed rate is indicated in the trust indenture at the time of issuance and is payable on specific dates until the bond matures. The benefit of owning a fixed rate bond is that investors know with certainty how much interest they will earn and for how long. As long as the bond issuer does not default or call in the bonds, the bondholder can predict exactly what his return on investment will be.
A key risk of owning fixed rate bonds is interest rate risk or the chance that bond interest rates will rise, making an investor’s existing bonds less valuable. For example, let’s assume an investor purchases a bond that pays a fixed rate of 5%, but interest rates in the economy increase to 7%. This means that new bonds are being issued at 7%, and the investor is no longer earning the best return on his investment as he could. Because there is an inverse relationship between bond prices and interest rates, the value of the investor’s bond will fall to reflect the higher interest rate in the market. If he wants to sell his 5% bond to reinvest the proceeds in the new 7% bonds, he may do so at a loss, because the bond’s market price would have fallen. The longer the fixed rate bond’s term, the greater the risk that interest rates might rise and make the bond less valuable.
If interest rates decrease to 3%; however, the investor’s 5% bond would become more valuable if he were to sell it, since a bond’s market price increases when interest rates decrease. The fixed rate on his bond in a declining interest rate environment will be a more attractive investment than the new bonds issued at 3%.
Other Considerations
An investor could reduce his or her interest rate risk by choosing a shorter bond term. He would probably earn a lower interest rate, though, because a shorter-term fixed rate bond will typically pay less than a longer-term fixed rate bond. If a bondholder chooses to hold his bond until maturity and does not sell it on the open market, he will not be concerned about possible fluctuations in interest rates.
The real value of a fixed rate bond is susceptible to loss due to inflation. Because the bonds are long-term securities, rising prices over time can erode the purchasing power of each interest payment a bond makes. For example, if a ten-year bond pays $250 fixed coupons semi-annually, in five years, the real value of the $250 will be worthless today. When investors worry that a bond’s yield won’t keep up with the rising costs of inflation, the price of the bond drops because there is less investor demand for it.
A fixed rate bond also carries liquidity risk for those investors who are considering selling the bond before its maturity date. This risk occurs when the the spread between the bid price and ask price of the bond is too wide. If this occurs, and the bond holder is asking (ask price) for more than investors want to pay (bid price), then the original holder may be placed in a scenario whereby they sell the security for a loss or significantly reduced rate, thereby sacrificing liquidity.
FAQs
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.
What is interest rate risk on fixed rate bonds? ›
Interest rate risk is the potential that a change in overall interest rates will reduce the value of a bond or other fixed-rate investment: As interest rates rise bond prices fall, and vice versa. This means that the market price of existing bonds drops to offset the more attractive rates of new bond issues.
What is the interest rate risk of a bond? ›
Interest rate risk is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates. Interest rate risk is mostly associated with fixed-income assets (e.g., bonds) rather than with equity investments. The interest rate is one of the primary drivers of a bond's price.
What are the risks of fixed income bonds? ›
First, there is uncertainty with the cash flow of the bond because an expected five-year cash flow might end early. Second, if the bond is called when the interest rate is low, then the investor is subject to reinvestment risk.
What is a fixed rate bond simple definition? ›
A fixed rate bond is a type of savings account that offers a fixed rate of interest for a set period of time.
What are the disadvantages of a fixed rate bond? ›
Disadvantages
- Bond rates can often be lower than investment returns.
- You can't access your money early.
- Not suitable for regular savers.
- Interest rates could rise after you lock into your fixed rate.
Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.
Is bonds a high risk or low risk? ›
Bonds in general are considered less risky than stocks for several reasons: Bonds carry the promise of their issuer to return the face value of the security to the holder at maturity; stocks have no such promise from their issuer.
Which bond has highest risk? ›
Junk bonds are debt securities rated poorly by credit agencies, making them higher risk (and higher yielding) than investment grade debt. A fixed-income security is an investment that provides a steady interest income stream for a certain period.
What are the four types of interest rate risk? ›
This booklet provides an overview of interest rate risk (comprising repricing risk, basis risk, yield curve risk, and options risk) and discusses IRR management practices.
All in all, Fixed Rate Bonds are considered one of the safer savings options available, as you know how much money you'll get back when your plan matures, and when this will be. You also avoid the risks involved with market volatility.
Are fixed rate bonds risk-free? ›
A key risk of owning fixed rate bonds is interest rate risk or the chance that bond interest rates will rise, making an investor's existing bonds less valuable. For example, let's assume an investor purchases a bond that pays a fixed rate of 5%, but interest rates in the economy increase to 7%.
Is it worth investing in fixed rate bonds? ›
A fixed rate bond is best thought of as a steady investment account because you know exactly what you'll be getting back and there are no market related elements that might affect your money for better or worse. Some things that mean a fixed rate bond could be right for you: A fixed interest rate.
Can you withdraw money from a fixed rate bond? ›
Normally, you can't withdraw money or close your Fixed Rate Savings Bond during its term.
What are the benefits of a fixed rate bond? ›
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.
What are the pros and cons of bonds? ›
Key Points
- Pros: I bonds come with a high interest rate during inflationary periods, they're low-risk, and they help protect against inflation.
- Cons: Rates are variable, there's a lockup period and early withdrawal penalty, and there's a limit to how much you can invest.
After bonds are initially issued, their worth will fluctuate like a stock's would. If you're holding the bond to maturity, the fluctuations won't matter—your interest payments and face value won't change.
What is interest rate risk in fixed deposits? ›
Risks on interest rates - Interest rate risk is one of the biggest risks while investing in FDs. If the interest rates are low and the FDs are locked in a fixed tenor, then the return earned will also be low.
What is interest rate risk in high yield bonds? ›
High yield bond: Corporate bonds rated below BBB- or Baa3 by established rating agencies. Interest rate risk: When interest rates rise, the market value of fixed-income securities (such as bonds) declines. Similarly, when interest rates decline, the market value of fixed-income securities increases.
What is the risk-free interest rate on a bond? ›
The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. The so-called "real" risk-free rate can be calculated by subtracting the current inflation rate from the yield of the Treasury bond matching your investment duration.
