Fixed interest

What Is Fixed Interest?

Fixed interest refers to an investment or debt instrument, within the broader category of Fixed Income Securities, that pays a predetermined and unchanging rate of interest over a specified period. This means the payments an investor receives, or a borrower pays, remain constant regardless of fluctuations in market interest rates. Common examples include traditional bonds, fixed-rate mortgages, and certificates of deposit (CDs). The predictable nature of fixed interest makes it attractive for income investing and for investors seeking stable cash flows.

History and Origin

The concept of fixed interest payments is intrinsically linked to the history of debt and lending, dating back to ancient civilizations. Formalized fixed-interest instruments, particularly government bonds, gained prominence as a means for states to finance wars and public projects. For instance, the Bank of England issued one of the earliest sovereign bonds in 1693 to fund a conflict with France. The evolution of central banking and modern financial markets further solidified the role of fixed interest securities in economic systems. The Federal Reserve Bank of San Francisco provides an overview of how financial instruments, including those with fixed interest, have developed over time as part of broader monetary policy and economic shifts.⁵

Key Takeaways

• Fixed interest provides predictable income streams through constant interest payments.
• The interest rate on fixed-interest instruments remains unchanged for their entire term or a specified period.
• Common fixed-interest investments include bonds, fixed-rate loans, and certificates of deposit.
• Fixed interest is sensitive to changes in market interest rates; when market rates rise, the value of existing fixed-interest investments typically falls, and vice versa.
• Investors often utilize fixed interest for capital preservation and stable cash flow within an investment portfolio.

Formula and Calculation

For a basic fixed-interest instrument like a bond, the periodic interest payment (coupon payment) is calculated as a fixed percentage of the bond's face value.

The formula for calculating a single fixed interest payment is:

Where:

• Face Value (or Par Value): The principal amount of the bond, typically repaid at maturity date.
• Fixed Interest Rate: The annual rate of interest specified at the time of issuance, often referred to as the coupon rate for bonds.

For example, a bond with a $1,000 face value and a fixed interest rate of 5% would pay $50 in interest annually ($1,000 x 0.05). If payments are semi-annual, each payment would be $25.

Interpreting Fixed Interest

Interpreting fixed interest involves understanding its stability and how external factors affect its value. A fixed interest rate provides certainty regarding future cash flows, which is valuable for financial planning. However, this predictability comes with trade-offs. The fixed nature of the payments means that the real returns from such an investment can be eroded by inflation. If inflation rises, the purchasing power of the fixed interest payments decreases. Conversely, in a deflationary environment, the real value of fixed interest payments increases. Investors also consider the yield of a fixed-interest instrument, which reflects its return relative to its current market price.

Hypothetical Example

Consider Sarah, who invests $10,000 in a 5-year corporate bond with a 4% fixed interest rate, paid annually.

• Year 1: Sarah receives $400 in interest ($10,000 x 0.04).
• Year 2: Sarah receives another $400.
• Year 3: Sarah receives another $400.
• Year 4: Sarah receives another $400.
• Year 5: Sarah receives her final $400 interest payment and the original $10,000 principal back at maturity.

Throughout the five years, Sarah's annual interest income remains consistently $400, demonstrating the predictable nature of fixed interest. This steady income stream can be beneficial for investors focused on regular payments, potentially avoiding the volatility associated with other asset classes.

Practical Applications

Fixed interest instruments are fundamental components of global financial markets and are utilized by governments, corporations, and individuals for various purposes. Governments issue fixed-interest bonds (like Treasury bonds) to finance national debt and public spending, while corporations issue them to raise capital for business expansion or operations. For individual investors, fixed interest investments provide a stable source of income and can serve as a conservative anchor in a diversified investment portfolio.

The Securities and Exchange Commission (SEC) provides investor bulletins explaining the characteristics and risks of bonds, highlighting their role in financing various entities and offering fixed payments.⁴ The International Monetary Fund (IMF) also regularly assesses the stability of global financial markets, including the fixed income sector, given its significant size and interconnectedness with the broader economy.², ³

Limitations and Criticisms

While fixed interest offers stability, it is not without limitations. A primary concern is inflation risk. As the purchasing power of money declines, the fixed payments from a bond become less valuable in real terms. This can significantly erode the actual returns for investors, especially during periods of high or unexpected inflation. Reuters has reported on how inflation fears influence investor scrutiny of fixed income.¹

Another limitation is interest rates risk. If market interest rates rise after a fixed-interest instrument is purchased, the existing instrument becomes less attractive compared to newly issued ones with higher rates. This can lead to a decrease in the market present value of the older fixed-interest instrument if an investor needs to sell it before its maturity date. Furthermore, fixed interest securities, like all debt instruments, carry default risk (also known as credit risk), where the issuer may fail to make promised payments.

Fixed Interest vs. Variable Interest

The key difference between fixed interest and variable interest lies in the stability of their interest rates.

Investors choose between fixed and variable interest based on their outlook on future interest rates, their desire for payment stability, and their risk tolerance. Fixed interest offers peace of mind through predictability, while variable interest may offer higher potential returns if rates rise, but also carries the risk of higher payments for borrowers or lower income for investors if rates fall.

FAQs

What is the primary benefit of a fixed interest rate?

The primary benefit is the predictability of payments or income. For a borrower, monthly payments remain constant, making budgeting easier. For an investor, the regular, unchanging compounding payments provide a stable income stream, crucial for those relying on their investments for living expenses.

How does inflation affect fixed interest investments?

Inflation erodes the purchasing power of money. With fixed interest, the nominal payment amount remains the same, so its real value (what it can buy) decreases during periods of rising inflation. This is a significant risk for long-term fixed-interest holdings, impacting their real returns.

Are all bonds considered fixed interest instruments?

Not all bonds are fixed interest. While most traditional bonds offer a fixed coupon rate, there are also variable-rate bonds (also known as floating-rate notes) whose interest payments adjust periodically based on a benchmark rate. Additionally, inflation-indexed bonds adjust their principal value based on inflation, indirectly affecting their interest payments.

Can fixed interest rates change after I've invested or borrowed?

No, the fixed interest rate itself does not change on a specific instrument once it has been set for its term. If you have a fixed-rate mortgage or own a fixed-coupon bond, your payment or income stream will remain constant. However, the market value of that investment can fluctuate if prevailing interest rates change, affecting its duration.