Interest Bearing Securities Financial Management

Question: Discuss about the Interest Bearing Securities for Financial Management. Answer: Introduction: Money market is that part of financial market where the securities are traded which is liquid and are traded for shorter term and the capital market is that portion of financial market where the securities are traded for long term. In addition, interest-bearing securities are those securities, which yield interest (Faure 2015). The interest-bearing instrument is nothing but the claim against the issuer of the loan. Yield is nothing but the interest rate, which is paid to the security owner. Depending upon the issuer of the instrument, there are different kinds of interest bearing securities (Brown 2012). Some other form of investment include such interest bearing securities where the rate of interest against inflation and so the real interest rate is guaranteed. Discussion: The types of interest bearing securities is dependent on factors such as the issuer of the security, the security provided by the issuer for loan, form of interest payment and the term of maturity. The interest on the securities instrument is paid either as a floating or fixed rate of interest. Different types of interest bearing securities Bonds are one of the interest bearing instruments and the interest paid on bonds can be at fixed rate or fluctuating rate. In case of fixed rate, the interest rate is normally fixed at the beginning and applies to the whole term. The floating rate fluctuates and it is fixed for the period of three months in a year. It is based on NIBOR interest rate. There are also zero coupon bonds, which does not pay any interest as the bonds are purchased at discount rate. The risks that the interest bearing instruments carries with it arise from the change in the price during the term is due to the changes in the market interest rate and also due to the risk that comes along with the possibility of the issuer not repaying the loan (Fong et al. 2015). However, the risk of loss on the interest-bearing instrument is lower than for shares. If there is a rise in market interest rate, the price of interest bearing instruments issued in the previously having fixed rate of interest will fall as there is higher interest return on such loans because new loans have been issued with the interest rates that follows the market rates. Bonds, which are issued by the government or countries, are considered as risk free with respect to redeeming it at value, which is pre, determined. While there is always some risk of default, so for this the issuer of bond pay risk premium or provide any collateral to the bond buyer (Lewis 2016). Another kind of interest bearing instruments is debentures. Such types of instruments are associated the higher possibility of risks if the buyer has any difficulty repaying the loan amount. There are subordinated bonds for which the investors are required to make an enquiry about it by comparing it to the other debentures and liabilities of the issuer. Treasury bills- it is another interest-bearing instrument. It is a means by which capital is raised and the return of the interest along with the capital is guaranteed to the person investing. T-bills are also issued at discount. The interest payable on the treasury bills is taxable, it is mainly attracted to the conservative investors, and the yield is slightly lower than other comparable securities (Nyawata 2013). Commercial deposits- this instrument is new in the money market. They are promissory notes of short term and it is mostly issued by nationally reputed, credit worthy, leading and such corporations, which are highly rated. Any unincorporated, incorporated bodies or any person, bank or company can make investment in commercial paper. The interest rate payables on commercial paper are determined by the market. The costs of such papers are comparable to the bank credits and are comparatively lower (Kacperczyk and Schnabl 2013). Certificate of deposits- This are regarded as marketable receipts in registered form of funds, which are deposited in a bank at a specified rate of interest and for the specified rate of interest. The security is a fixed interest bearing and liquid, negotiable, transferable, maturity dated and riskless money market instrument. The maturity period varies between three months to one year. This type of security is more attractive than bank deposits. Role of interest bearing securities in portfolio management: The inclusion of interest bearing securities in the portfolio is an important investment strategy. It helps in minimizing the volatility and stabilizing the portfolio. They are considered as safe havens compare to the stocks or equities. In order to improve the yield the investors may be required to purchase the lower credit quality bonds. The investors can diversify the portfolio by including various interest bearing securities. When the securities such as bonds are low then the investor can sell off the stocks in the portfolio and vice versa. The portfolio can be rebalanced properly if it consists of diversified securities. The bond portion of portfolio would provide the added degree of security to the portfolio (Martinsuo 2013). Asset allocation: The primary delivery of the performance of portfolio is the allocation of asset that is the amount of money the investor has invested in particular security in relation to other. The majority of the performance of the portfolio comes from the allocation of assets in comparison to the selection of security, timing of the market and other factors. The role of bond in the portfolio does not change when the interest rate or the markets changes. Risk tolerance is an important factor in determining the asset allocation (Chang and Tian 2016). The amount of risk the investor can handle to achieve their investment goals. Suppose the investor requires 9% return, it would be recommended that the investors should make 60% investment in aggressive stocks and 40% in interest generating securities and cash equivalent. If the lower percentage of stocks is taken, the investor will run the risk of not achieving his targeted return. A portfolio cannot be fully comprised of the interest bearing securiti es. However, if there is a market fluctuation, the portfolio can be rebalanced. The 60:40 portfolio allocation can be revised to 55:45 if suppose the performance of the stock market is not good. Rebalancing is the key strategy in order to keep the portfolio in tune with the market (Cumming et al. 2014). The longer the term of bond, the more is the damage as it can be seen from the above graph. At the end of 2013, the US treasury was yielding about 3%. The chart shows what would happen to the price of the bonds if the interest rate fluctuates. Here the 3% bond is considered. If the interest rate went up to 1%, the ten-year bond would yield only value of 91.8%. In the same scenario, 30-year bond would lose about 18% of its value. Duration: Duration is an important tool, which helps in immunizing the portfolio from the risk of changes in interest rates. It tells the sensitivity of interest rates of a portfolio. Duration analysis is a way in which the return on fixed income securities is understands. It measures the risks associated with the fixed income securities. Duration is very important in measuring the fixed income in portfolio management. In order to manage the risks associated with the portfolio, the technique gap management is introduced in the concept of duration. The duration gap is reduced when the fixed income bearing securities as it served to lengthen the liabilities of the assets class. The portfolio manager wants to immunize the future accumulated values of the funds against the movement of interest rate at some future date. When the assets and liabilities are matched duration wise the ability of the portfolio of the assets to meet the obligations of the investors would remain unaffected by the movement s of the interest rates (Arnold et al. 2015). Convexity Convexity measures the changes in the duration with respect to changes in the interest rate. The relationship between the price and yield is convex. It is a measure of changes in the bond price or any fixed income securities corresponding to the changes in the interest rates. Generally, lower the convexity higher would be the coupon. A 10% bond is less sensitive to the 5% bond. Because the fixed income securities has a call feature so the callable bonds or CDs and if their yield falls to a low level then it would display negative convexity. Therefore, when the yield decreases then the duration will also decrease (Cerovic et al. 2014). The portfolio managers should take into account while managing the interest rate risks. Not all the convexity is beneficial in a portfolio. When the interest rate falls then the security will exhibit appreciation in price if it has positive convexity. In order to hedge against the decline of the interest rate, portfolio managers can implement the strategy of adding positive convexity to the portfolio. Such strategies can be tailored suiting to the clients portfolio specifically (Goyenko 2013). Risks faced by the investors or the portfolio managers in investing in interest bearing securities: Some of the risks faced by the investors of interest bearing securities: Selection risks: Some of the reasons regarding investment in such securities cannot be anticipated. It results in the underperformance of the securities due to the unanticipated reasons and this is selection risks faced by an investor or the portfolio managers. Timing risks: The risk that the securities are performing poorly when it is purchased. Market risks: the risks that market for such securities would fall say bond market and this lead to decline in the value of the individual securities regardless of its fundamental characteristics. Inflation risks: inflation reduces the cash flow of the bonds investors as it effect the purchasing power. The higher interest rate is due to the inflation and it is known that the there exist inverse relationship between the price of bonds and interest rate. Therefore, higher interest rate would lead to fall in the prices if the interest rate is rising. Liquidity risk: It is the risk that is associated with the difficulty of the investors in finding the buyer to sell off the securities and they might be forced to sell at the discounted price compare to the market value. After the period the bonds are issued when the bonds, which are typical, is of high trading volume, at that time the bonds are liquid. Bonds, which lower, rated or when its credit is downgraded or the bonds, which are issued by the infrequent issuer, suffer the liquidity risk (Drehmann and Nikolaou 2013). Default risks: this is risk associated with the bond is that the issuer of the bond would make default in the payment of the interest as well as principal amount. If the payment is not made as per the documentation, the issuer can make default in payment. Recommendation: The interest bearing securities should form a part of the portfolio and whether the proportion of such securities should be more or less, than the stocks depend on the nature of the investor if he is risk averse or risk lover seeking more growth. The decision of the investors is driven by the macroeconomic factors and on the nature of the investors. The risk adverse investors should invest in debentures, treasury bills and high rated municipal bond that generates a fixed return. Credit rating and the return on investment should be considered by the investor seeking to invest in such securities. However, diversifying the portfolio would improve the performance, so the stocks should also form a part of the portfolio. The risk of loss on interest bearing instruments is lower than the other capital market instruments such as equities where the return is not certain. The major risk faced by the investor while investing in the interest bearing bonds is the fluctuation of the interest rates. The loans without collateral are considered more risky than the one, which come with some sort of collaterals. The number of factors including perception of the investors regarding inflation, business cycle, affects the interest rate and the prices in the capital market. The average returns from investment in the interest bearing securities have been found to be lower and stable. If the bond is of higher risks, the yield it would be carrying will also be higher as taking the higher risks has to be compensated by giving the higher returns. The financial markets of the securities bearing interest is found to be less volatile and is less vulnerable to the price swings. Conclusion: In general, the conclusion can be made that investors are keen mainly on investing in the less risky product for the long term. Though there are some forms of risk associated with the interest bearing securities, the investors should appoint the portfolio managers in handling their portfolios. The allocation of asset in the portfolio is rebalanced gauging the performance of various securities. However, the bond market is no exception to the higher return and higher risks. To get the most benefits from the bond or T bills market, the managers increases the average duration when the rate is declining and vice versa to minimize the negative impact. Reference: Arnold, T., Earl Jr, J.H. and Marshall, C.D., 2015. A Quick Approximation for Modified Bond Duration and Convexity.The Journal of Wealth Management,18(3), pp.53-56. Brooks, P.M., 2014. Money Market Funds: Analyzing Reform. Brown, R., 2012. Analysis of investments management of portfolios. ÄŒeroviĆ¡, S., PepiĆ¡, M., ÄŒeroviĆ¡, S. and ÄŒeroviĆ¡, N., 2014. Duration and convexity of bonds.Singidunum Journal of Applied Sciences,11(1), pp.53-66. 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