[Document title] | Reference Notes

CHAPTER 8
THE FIXED INCOME SECURITIES

1. The Meaning of Fixed Income Securities

The securities or financial assets that provide fixed income to the investors are known as
the fixed income securities. The debt securities like bonds, debentures and limited life
preferred stocks are examples of the fixed income securities. Since the securities provide
fixed income, it is less risky than the equities or common stocks as dividends are
uncertain. The holders of the debt securities or the fixed income securities are called the
creditors. The debt securities and limited life preferred stocks have prior claim over the
income and assets (in case of liquidation) compared to the equities or common stocks.
However, these securities cannot participate in super normal profit.

2. Types of Fixed Income Securities

The fixed income securities can be short term or the long term. The short term securities
are called the money market instruments while the long term securities are called the
capital market instruments.
2.1. Money Market Instruments
The securities with the maturity of one year or less are the money market
securities. Money market securities are highly liquid which reduces the risk
associated with it. Thus, these securities have modest return.
i. Treasury Bills: Treasury bills are issued by the Central Bank on behalf of
the government. It is denominated at high par value due to which
individual investors are less likely to invest in it. It is issued at discount
from par and matures at par. The difference in the par value and
discounted purchase price is the return to investors. The return is fixed.
In Nepal, NRB issues the T-bills with maturity of 28 days, 91 days and
270 days every week. The par value in NPR 25,000.
ii. Negotiable Certificate of Deposit: It is the certificate sold or issued by
the bank against the deposit maintained at the bank or the par value
paid. It has fixed interest rate that is used to calculate the interest
payment at the end of the maturity. The investors receives principal plus

1|Fundamentals of Investment, BBS IV Year

 [Document title] | Reference Notes
interest amount on maturity. The term negotiable refers to the provision
that the CDs can be sold in the secondary market before its maturity.
iii. Eurodollar deposit: The deposit account maintained in dollars outside the
US in foreign bank or branch of the US bank is known as the Eurodollar
deposit. For instance, if a person holds a dollar deposit account in
Japanese Bank in Japan, it is Eurodollar deposit. The banks provide fixed
low rate of interest on such accounts.
iv. Commercial Papers: CPs is short term promissory notes issued by highly
credit worthy firms and corporations to raise short term funds usually for
30 and 60 days. The commercial papers can be issued at discount or at
par. When issued at discount, it matures at par whereas it provides fixed
interest if it is originally sold at par. In any way, the investors receive
the fixed return. Commercial Papers are not issued in Nepal yet.
v. Bankers Acceptance: It is the promissory note guaranteed by the bank
which usually has maturity of 90 days that can extend up to 120 days.
During the international trade, the beneficiary or exporters bank draws a
draft (the trade cost including additional charges) on the applicant or
importers bank which is then endorsed by marking the accepted by the
importers bank. Now the draft is called the bankers acceptance which
can be sold in the secondary market.
vi. Repurchase Agreement: Repos are the monetary policy tools that are
exercised by the central bank in order to manage the liquidity situation
of the financial market. In Repos, there is counter party for which the
transaction is reverse repo. The central bank sells the securities with
promise to purchase it back in future date at higher prices than it has
sold today.

2.2. Capital Market Instruments

The securities with maturity greater than one year are known as the capital
market securities. These are long term source of financing for the issuer. Both
government and private sector issue the long term capital market securities
like bonds, debentures and mortgages.

2|Fundamentals of Investment, BBS IV Year

 [Document title] | Reference Notes
2.2.1. Government Securities
The government issues numbers of debt securities to raise the required capital
(deficit budget financing) nationally and internationally. The government securities
are safest of all other securities as there is no chance that the government will
default on its payments.

i. Treasury Notes: These are the promissory notes with maturity 1 year to
10 years sold at par value paying fixed interest.
ii. Savings Bonds: Saving bonds are non-negotiable instruments issued by
government. Non-negotiable means the saving bonds cannot be traded
in the secondary market and it should be held until the maturity.
iii. Development Bonds: The promissory notes with maturities usually
ranging between 3 years to 10 years are the development bonds. It can
be purchased by banking institutions, non-banking institutions and
individual. These bonds are issued to finance the development projects
of the nation.
iv. National Saving Bonds: National Saving Bonds are issued by the central
bank on behalf of the government. It is used for internal debt financing.
It can be purchased by non-banking institution and individuals only.
These bonds are usually issued for 5 years maturity.
v. Citizen Saving Certificate: Citizen Saving Certificate can only be
purchased by individuals. It is normally floated for 5 years period. It
carries the fixed coupon or interest payment payable on semi-annual
basis.
vi. Special Bond: Special bonds are issued to finance the special occasion
for special or the particular sector. It is issued be the government if the
government lacks fund to pay overdraft interest, cash subsidy and
commission etc.

2.2.2. Corporate Securities

Corporate securities are issued by the private or corporate sector to finance their
long term financing needs. It is exposed to relatively higher risk compared to the

3|Fundamentals of Investment, BBS IV Year

 [Document title] | Reference Notes
government securities due to which the yield of corporate securities are higher
than the yield of the government securities.
i. Corporate Bonds: Corporate Bonds are long term promissory notes
usually issued for more than 10 years. These bonds usually carry fixed
coupon or interest payable semi annually. The bonds are redeemed on
maturity at par value.
ii. Preferred stocks: Preferred stocks are hybrid securities having the
feature of both debt and equity. The preferred stocks have fixed
dividend payment like the bonds while it exists for indefinite period as
equities. However, limited life preferred stocks are also in use.
iii. Common Stocks: Common stocks represent the equity ownership. The
stocks do not have fixed maturity and fixed dividend payment. The
dividend could vary or may not be distributed some time. The issuance
of the common stocks does not bind the company to pay dividend
without failure.
2.3. Bond’s Exposure to the Risk
There are certain risks associated with the bond issues. Those risk are briefly
discussed below:
Interest Rate Risk: It stems from the changing interest rates. The bond price is
inversely related to the interest rates. Therefore, when interest rate changes
the bond prices tend to change with it.
Purchasing Power Risk: Purchasing power risk is caused by the inflation.
Generally, the inflation is expected to increase in future. Therefore, the
inflation deteriorates the return from the bond as the bonds pay the fixed
coupon or interest even though the yields are rising with inflation.
Business or Financial Risk: The issuer promises to pay interest periodically and
maturity value on maturity date. But, if the issuer defaults or does not pay as
per the agreed terms, it is business or financial risk or default risk.
Government bonds are free of this type of risk.
Liquidity Risk: The liquidity risk arises when the bonds are not readily sellable
in the secondary market. Usually, the bonds are traded over the counter. But,
insufficient development of OTC market and lack of separate bond market
makes it difficult to sell the bonds.

4|Fundamentals of Investment, BBS IV Year

 [Document title] | Reference Notes
2.4. Important Topics from This Chapter
Sinking Fund: The sinking fund is the provision that the bonds are
retired orderly over the life of the bond. The firm has to bear huge
financial liabilities if the firms are to redeem all the bonds on maturity.
Instead of waiting for the maturity period, the issuer of the bond
maintains the funds with the bond trustee which is then invested by
the trustee into money market instruments. The accumulated value of
this fund can be used to redeem or repay the par value on maturity. It
reduces the huge financial burden for the bond issuer.

Secured and Unsecured Debt/Bond: The debt or bond backed by

particular property or asset of the issuer is known as secured debt. In
case of default, the holder of the bond or debt can claim the possession
over the collateralized assets. In other hand, unsecured debt does not
have any assets or properties backed against it. Unsecured debt is
more risky due to which it yields higher than secured debt. Debenture
is an example of unsecured debt.

Bond Ratings: Bond ratings are the grades provided to the bonds by
rating agencies. The bond ratings help the investors to make
investment decision. Higher the grades, the bonds are of good quality.
The bonds with lower ratings are more risky bonds. The bind ratings
are useful in determining the required rate of return. Usually, low
grade bonds are called junk bonds and it should yield higher to attract
the investors. S&P and Moody’s are some widely used bond ratings.

5|Fundamentals of Investment, BBS IV Year