Fixed rate assets: Meaning, Criticisms & Real-World Uses

What Are Fixed Rate Assets?

Fixed rate assets are investment products that provide a predictable stream of income payments over a defined period. These assets typically involve lending money to an entity, such as a government or a corporation, in exchange for regular interest payments and the return of the initial principal at a predetermined maturity date. They belong to the broader financial category of fixed income and are characterized by their stable coupon payment structure, which remains constant throughout the life of the investment, regardless of fluctuations in prevailing market interest rates. Common examples of fixed rate assets include government bonds, corporate bonds, and certain types of certificates of deposit (CDs). Investors often seek fixed rate assets for their potential for capital preservation and consistent income generation, making them a foundational component of many diversified investment portfolios.

History and Origin

The concept of fixed income securities, the precursors to modern fixed rate assets, dates back centuries. Early forms involved rulers borrowing from wealthy individuals or institutions, often with a promise of regular payments. The first recorded bond in history dates back to 2400 B.C. in Mesopotamia, where a stone guaranteed the payment of grain.¹² More formally, city-states like Venice began issuing government bonds, known as presiti, in the 1100s to fund wars, evolving their bond markets significantly by the 14th century to allow trading of these securities.¹¹

The first official government bond issued by a national government was by the Bank of England in 1694 to finance a war against France.¹⁰ These early bonds sometimes combined features of lotteries and annuities.⁹ In the United States, the government first issued "loan certificates" in 1776 during the Revolutionary War to raise funds, with private citizens purchasing over $27 million in these early bonds.⁸ This established a tradition of government borrowing that continues to this day, forming the bedrock of the fixed rate asset market.

Key Takeaways

Fixed rate assets provide a predetermined, unchanging stream of income payments.
The interest rate, or yield, on these assets is set at the time of issuance and does not change.
They are a core component of fixed income portfolios, sought after for stability and income.
While offering payment predictability, their market value can fluctuate inversely with changes in interest rate environments.
Examples include government bonds, corporate bonds, and certain mortgage-backed securities.

Formula and Calculation

The value of a fixed rate asset, particularly a bond, is primarily determined by the present value of its future cash flows, which consist of periodic coupon payments and the final principal repayment. The formula for calculating the price of a bond is:

P = \sum_{t=1}^{N} \frac{C}{(1+r)^t} + \frac{F}{(1+r)^N}

Where:

(P) = Price of the bond
(C) = Annual coupon payment (fixed dollar amount)
(r) = Market discount rate or yield to maturity
(F) = Face value (par value) of the bond
(N) = Number of periods to maturity

This formula discounts future cash flows back to their present value using the market's required rate of return.

Interpreting Fixed Rate Assets

Interpreting fixed rate assets involves understanding their core characteristics and how they react to economic conditions. The primary appeal of a fixed rate asset lies in its predictable income stream. For an investor seeking stable cash flow, a fixed rate asset like a bond that pays a 5% coupon rate means they will receive a consistent percentage of the face value in interest payments until maturity.

However, the market value of existing fixed rate assets moves inversely to changes in prevailing market interest rates. If market rates rise after a bond is issued, the bond's fixed coupon becomes less attractive, causing its price to fall. Conversely, if market rates fall, the fixed coupon becomes more appealing, and the bond's price will rise. This concept is captured by a bond's duration, which measures its price sensitivity to interest rate changes. Understanding this inverse relationship is crucial for investors, as it impacts the total return of their fixed rate asset holdings, especially if they need to sell before maturity.

Hypothetical Example

Consider an investor, Sarah, who purchases a newly issued corporate bond. The bond has a face value of $1,000, a fixed annual coupon rate of 4%, and a maturity date of 5 years.

Purchase: Sarah pays $1,000 for the bond.
Annual Income: Each year for five years, the bond will pay her 4% of the $1,000 face value, which is $40 ($1,000 * 0.04). This is her fixed income stream.
Maturity: At the end of the 5-year term, the company will return the $1,000 principal to Sarah.

In this scenario, Sarah knows exactly how much income she will receive each year and when her initial investment will be returned, assuming the issuer does not default. If market interest rates were to rise to 6% shortly after Sarah bought her 4% bond, new bonds would offer a higher coupon. Sarah's bond, still paying 4%, would then trade at a discount in the secondary market to make its effective yield competitive with the new 6% bonds. This illustrates the interest rate risk associated with fixed rate assets.

Practical Applications

Fixed rate assets play a vital role across various financial applications, from individual investment planning to large-scale market functions.

Investment Portfolios: They are a cornerstone of portfolio diversification, providing a stable income component and acting as a counterbalance to more volatile assets like equities. They are particularly favored by investors seeking consistent income for retirement or other financial goals.
Government Financing: Governments heavily rely on fixed rate bonds, such as Treasury bonds and notes, to finance public spending and manage national debt. These bonds are often considered among the safest fixed rate assets due to the issuing government's creditworthiness.
Corporate Debt: Companies issue corporate bonds as a way to borrow money from investors to fund operations, expansions, or refinance existing debt. The terms, including the fixed interest rate, are set based on the company's credit rating and prevailing market conditions.
Central Bank Operations: Central banks, like the Federal Reserve, use government bonds in open market operations to influence the money supply and implement monetary policy. The yields on these fixed rate securities are closely monitored as indicators of economic health and future interest rate expectations. Daily data on selected interest rates, including Treasury securities, is published by the Federal Reserve.⁷
Regulatory Requirements: Financial institutions often hold fixed rate assets, especially high-quality government bonds (e.g., investment grade bonds), to meet liquidity requirements and regulatory capital standards.

Limitations and Criticisms

While fixed rate assets offer stability and predictable income, they are not without limitations and criticisms.

One significant drawback is their vulnerability to inflation. When inflation rises, the purchasing power of the fixed income payments and the principal repayment diminishes over time. This means that while the nominal payments remain constant, their real value decreases. Research has shown that households are often well-informed about the erosion of nominal assets due to inflation but are less aware of how it erodes fixed-rate debt.⁶ Unexpected inflation can significantly erode the real value of fixed rate assets, transferring wealth from savers to borrowers.⁴, ⁵

Another limitation is interest rate risk. If market interest rates rise, the market value of existing fixed rate assets with lower coupons will fall, leading to potential capital losses if sold before maturity. Conversely, in a falling interest rate environment, reinvestment risk arises; as existing fixed rate assets mature, investors may have to reinvest their capital at lower prevailing rates, reducing their overall income.

Furthermore, fixed rate assets carry credit risk, also known as default risk. This is the risk that the issuer of the bond will be unable to make its promised interest payments or repay the principal. While government bonds typically have very low credit risk, corporate bonds have varying degrees of risk depending on the issuer's financial health. The U.S. Securities and Exchange Commission (SEC) provides guidance on understanding corporate bonds and their associated risks.³

Fixed Rate Assets vs. Floating Rate Assets

The key distinction between fixed rate assets and floating rate assets lies in the nature of their interest payments.

Fixed Rate Assets: These assets, as discussed, pay a constant interest rate throughout their life. The coupon is set at the time of issuance and does not change. This predictability of income is a primary characteristic. Examples include traditional corporate bonds and government bonds.

Floating Rate Assets: Also known as variable rate assets, these investments have interest payments that adjust periodically based on a predetermined benchmark rate, such as the prime rate or LIBOR (or its successors). If the benchmark rate rises, the interest payments on the floating rate asset will also increase, and vice versa. This feature makes floating rate assets less sensitive to changes in market interest rates over their lifetime, as their income stream adapts. Examples include floating rate notes, some bank loans, and certain types of mortgage-backed securities.¹, ²

While fixed rate assets offer income stability in nominal terms, floating rate assets offer a hedge against rising interest rates by adjusting their payouts. The choice between the two often depends on an investor's outlook on future interest rate movements and their desire for income predictability versus interest rate sensitivity.

FAQs

What is the main benefit of owning fixed rate assets?

The primary benefit of owning fixed rate assets is the predictable and regular stream of income payments they provide. This makes them attractive for investors seeking stable cash flow.

Are fixed rate assets risk-free?

No, fixed rate assets are not risk-free. They are subject to various risks, including interest rate risk (where their market value changes inversely to interest rates), inflation risk (where inflation erodes the purchasing power of fixed payments), and credit risk (the risk of issuer default).

How does inflation affect fixed rate assets?

Inflation negatively impacts fixed rate assets because the fixed income payments and the final principal repayment lose purchasing power over time. The real return on the investment decreases as inflation rises.

Can the value of a fixed rate bond change before maturity?

Yes, the market value of a fixed rate bond can change before its maturity date. This is primarily due to changes in prevailing market interest rates. If market rates rise, the bond's value will typically fall, and if rates fall, its value will typically rise.