What is fixed income?
The so-called fixed income – Treasury bills, government bonds, obligations … – are debt instruments issued by a state or private company, homogenized with the same value that allows them to be exchanged between investors.
Difference between government bonds and Treasury bills
One of the main differences is the term of the issue:
They are for emissions of less than 18 months . The discount formula is used by which we buy a nominal, minus the interest rate applicable to the operation, and the total nominal amount is returned to us at maturity .
Government bonds and obligations
They are for issues over 18 months. The payment of coupons is used, where at the initial moment we pay the nominal or a percentage on it and we are paid coupons (quarterly, semi-annual or annual) of the% on the nominal being, on the expiration date of the product , when the nominal plus the last corresponding coupon is returned .
What are government bonds?
Among all these instruments, the government bond is a long-term security . Government bonds and obligations are issued by the Government to finance the public deficit .
Difference between government bonds and obligations
The only difference between a bond and an obligation is their repayment term :
- Government bonds and obligations are issued and “promise” a fixed return that is paid in annual payments.
- Securities issued at a value ( nominal value ) pay a specified explicit interest on the investment . That is, a 3% bond will periodically pay the equivalent of 3% of the initial investment.
- Issues are made through competitive auction and by tranches to ensure high liquidity.
- Treasury bills are short-term .
- The bonds are issued for 3 and 5 years.
- The bonds are issued for 10, 15 and 30 years.
- They are issued in nominal amounts of € 1,000 or multiples of this amount.
Where are government bonds and obligations traded?
These products are then listed on the market during their life span in order to offer the investor the option to sell or buy them before reaching their end , which will be when they return all the invested capital to the investor. Thus, the real price of the security may be above, below or at par with the nominal value during its life (1,000 euros per security), this may depend on:
- The proximity or remoteness of the coupon payment (interest on the nominal amount).
- The interest of the secondary market at the time of purchase
- Health of the economy of the country or of the issuing company.
What is the profitability of government bonds?
The profitability is predetermined throughout the life of the government bond (coupon) so that if it is maintained until its maturity, the investor will know exactly how much and when it will be obtained, as long as the issuing company or body complies with the payments.
Currently there are other more sophisticated types of bonds, with variable interest linked to certain indicators, such as interest rates (Euribor, etc.), stock indices, or even the evolution of a certain share , index, etc. What makes the profitability of these specific products is no longer defined from the beginning.
The profitability is related to the credit quality –capacity to pay the debt– of the issuer, so the worse the credit rating ( rating ), the greater the risk and therefore the higher the profitability offered will have to be for an investor to be interested .
How do interest rates affect government bonds?
What most affects the performance of fixed income is the evolution of interest rates . The investor who wants to sell a fixed income security before its repayment date runs an interest rate risk. This risk will be greater, the longer the term of repayment of the title. In other words, if interest rates rise, new issues of fixed income in the primary market will have to increase their emission rates and changes in the market for fixed income already issued will fall.
In Finance for Everyone they explain it in a very simple way: an investor buys a newly issued bond with a 6% coupon, which means that it generates € 60 per year in interest for every € 1,000 of nominal value. But within a year interest rates go up. Your bond will continue to offer only € 60 per year, but new issuers will now offer higher returns in line with the new rates (eg 7%). As investors now have the opportunity to buy new bonds, like the one you have but that offer a 7% return, the only option that the inverse has to sell yours at 6% will be to sell it below its nominal value (that is, say, discounted).
In the same way, if interest rates fall, the new bond issues will offer returns below 6%. This will make your bond more attractive to other investors, and they will be willing to pay you a price for yours above its face value.
To reduce the risk of interest rate or repayment risk, it is important to contract securities with repayment terms in line with your financial objectives.
Inflation expectations : the coupons that pay the fixed income are nominal over time and if inflation rises, the real value of the coupon falls and the profitability of that fixed income is lower.
How to buy a government bond?
The purchase of a government bond , or what is the same, the subscription of public debt can be carried out through several channels:
- A government bond can be purchased at any Banco de España office
- A government bond can also be purchased through the Public Treasury website , under the option: “securities purchase and sale service”
- In financial entities (banks or savings banks) and in securities companies and agencies. This option is the simplest because it guarantees you greater peace of mind. Through the Bankinter broker, you can contract a wide range of public and private debt issues , both national and foreign, with the greatest reliability.
What are treasury bills?
The letters of the Treasury fixed income securities are short – term represented exclusively by book entry account . The Bills are issued with a minimum amount of 1,000 euros, with higher requests having to be multiples of 1,000 euros.
How is the profitability of the Treasury bills?
Treasury bills are issued for a lower amount than will be received at the time of redemption. The return will be the difference between the redemption price and your purchase price .
Currently the Treasury issues Treasury Bills with the following terms:
- 3-month Treasury bills
- 6-month Treasury bills
- 9-month Treasury bills
- 12-month Treasury bills
Glossary of basic terms for public debt instruments
- Primary market: it is the market generated at the time of issuance of the asset, when it is offered to investors for the first time.
- Secondary market: in this market securities that have previously been issued are traded. We must bear in mind that investing in fixed income does not mean that our investment must have a duration equal to the life of the asset, but that through this market we can undo (sell) or make an investment (buy) in this type of assets at any time.
- Principal : is the reference value of a bond.
- Explicit yield : it is the yield of a bond that is received through periodic payments (coupons).
- Implied yield : it is the yield obtained by the difference in prices at the time of issuance of the asset and its nominal or amortization price .
- Amortization: it is the return to the holder of a certain fixed income security of the invested funds, that is, the nominal value of the security.
- Nominal value: it is the theoretical value that is established as a unit price within a certain issue, it does not have to coincide with the acquisition price of the asset or with the amortization price. It is used for the calculation of coupons, if you have them.
- Maturity: amortization date fixed for a certain asset.