Fixed Interest

Fixed income (or fixed interest) securities pay interest at a rate that does not change with any external variable; the coupon payments are known in advance. Coupons are almost always all for the same amount and paid at regular intervals.

There are two risks with fixed income securities:

• Credit Risk
• Interest Rate Risk

Credit Risk is the risk that the issuer of a debt security such as a bond will default on the payments due. Credit risk is one of the main determinants of the price of a bond. The price of a debt security can be explained as the present value of the payments (of interest and repayment of principal) that will be made. This leaves the question of what determines the discount rate.

This can be decomposed into two elements:

• The risk free rate
• The risk premium or yield spread

The risk free rate depends only on the currency and the timing of payments.

The risk premium depends on the level of credit risk and the correlation of the the credit risk with the risk of holding other investments in accordance with the Capital Asset Pricing Model (CAPM).

Credit risk is also an issue for lenders such as banks. In this context the key is the risk of losses to the bank so correlation with the bank's other lending is what matters, not correlation with debt available in the market.

Interest Rate Risk is simply the risk to which a portfolio or institution is exposed because future interest rates are uncertain.

Bond prices are obviously interest rate sensitive. If rates rise, then the present value of a bond will fall sharply. This can also be thought of in terms of market rates: if interest rates rise, then the price of a bond will have to fall for the yield to match the new market rates.

The longer the duration of a bond the more sensitive it will be to movements in interest rates.
Shares are also sensitive to interest rates, again it is obvious that if interest rates change (and other things remain equal, which the Fisher effect suggests may not be the case) then Discounted Cash Flow (DCF) valuations will fall. In addition, the profits of highly geared companies will be significantly affected by the level of their interest payments.

Banks can also have significant interest rate risk: for example they may have depositors locked into fixed rates and borrowers on floating rates or vice versa.
Interest rate risk can be hedged using swaps and interest rate based derivatives.
Ways in which interest rate risk can be controlled include:

The usual alternative to fixed interest is a floating interest rates, which changes the nature of the interest rate risk. A change in interest rate will change the value of a fixed income security but not the income stream it pays. With a floating rate security the value will change less but the income stream will change.

The sensitivity of a fixed interest security to interest rates is measured by duration or, more accurately, modified duration.