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
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.
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 risk of fixed interest rates? ›
You do run the risk of losing out when interest rates start to drop but you won't be affected if rates start to rise. Having a fixed interest rate on your loan means you'll know exactly how much you'll pay each month, so there are no surprises. As such, you can plan and budget for your other expenses accordingly.
What is the meaning of fixed rate bond? ›
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? ›
It's also important to consider the disadvantages of a fixed rate bond. For example, you will lose access to your money for the length of the term. Before you open a fixed rate bond, evaluate your financial circ*mstances carefully. Make sure you can commit to putting your money away for a set period.
Are fixed bonds risky? ›
Are Fixed Rate Bonds a safe way to save? 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.
Do bonds have interest rate risk? ›
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 fixed interest low risk? ›
Fixed-income securities commonly have low returns and slow capital appreciation or price increases. This is the trade-off for lower risk. Their prices tend to decrease slower as well. The initial principal amount is often inaccessible, particularly with long-term bonds with maturities greater than ten years.
What has the most interest rate risk? ›
Long term bonds are most sensitive to interest rate changes.
What are the risks of fixed investment? ›
Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Any fixed income security sold or redeemed prior to maturity may be subject to loss.
Our expert says. If you have a lump sum of money sitting in your current account and aren't sure what to do with it, a fixed-rate bond could be the ideal option. Savvy savers need to be prepared to lock their money away for a time, but will also know from the outset what return they'll get when the bond matures.
What are examples of fixed bonds? ›
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.
What is an example of a fixed interest rate? ›
For example, banks will offer a 5% fixed interest rate on your savings for one year, which then drops to 1% or less. In many cases, this interest isn't paid until the account matures, so it's essentially a “golden handcuff” ensuring you remain a customer for at least a year.
What happens when a fixed rate bond matures? ›
Once your existing Online Fixed Rate Bond matures, we will transfer your savings to an Instant Savings Account that lets you access your money when you need it but still earn interest on your savings.
What are the benefits of a fixed rate bond? ›
Fixed-rate bonds are suitable for investors seeking stable returns with a low-risk tolerance, unlike equities, which may be volatile. 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.
What is not a benefit of a fixed interest rate? ›
You have less freedom – The fixed rate will not give you as much choice as the variable-rate can offer. You are locked to the rate you took until the end of the term. That means you cannot speed up your payment because you need to meet the cap you committed to set.
Which bonds have the highest interest rate risk? ›
The bond with the longest maturity and lowest coupon rate has the highest interest rate risk.
What bonds are most affected by interest rate risk? ›
Long term bonds are most sensitive to interest rate changes.
Is it worth investing in fixed rate bonds? ›
Savvy savers need to be prepared to lock their money away for a time, but will also know from the outset what return they'll get when the bond matures. Taking out a fixed-rate bond can be especially worthwhile when interest rates are high and you think they might fall in the future.
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.
