Fixed Income Securities Risk Mitigation Tools
Fixed income risks occur primarily because of the volatility in the bond market. Risks affect the market value of the security when it is sold, cash flow from the deposit when it is held, and extra income made by reinvesting the cash flows. Understanding the risks associated with fixed-income securities allows investors to make sound decisions.
Fixed Income Securities Risk Mitigation Tools
Fixed-income securities are known as one of the safest investment options. However, they have some risks associated with them, and an investor needs to buy protection against any unexpected losses from the investment in the bond market. There are various hedging tools available in the market that can protect the investor from the risks. There are various measures that can be adopted to cover such risks of an investment in exchange for a risk premium. Derivatives are the best ways to buy such protections for investors. Let’s look at some risk mitigation tools:
- Use of Credit Derivatives/ Credit Default Swaps: A protection contract is availed to the investors to protect against the default of a bond issuer. The credit derivative’s writer gets a premium to mitigate the investment risk until the contract matures. A contract under a credit default swap saves the investors from any kind of default by the issuer. Credit default swaps are also traded in global exchanges.
- Use of Interest Rate Derivatives: These are financial derivative contracts whose value is determined from one or multiple interest rates, prices of interest rate instruments or interest rate indices which can be used to protect the interest risk of a bond. Let’s look at a few of the interest rate risk hedging contracts:
- Forward Rate Agreements (FRAs): A forward contract where the buyer pays a fixed rate against a receipt of a variable rate for a single cash flow. The floating rate is linked to a benchmark interest rate such as MIBOR, where the principal is notional and is done in a single currency. The actual payments are calculated based on the agreed notional principal and are paid at mutually agreed time intervals. If the interest rate rises, the floating rate increases and the fixed rate receiver loses value.
- Swaps: It is a derivative contract used by two parties to exchange the cash flows or liabilities from two different financial instruments. They offer great flexibility in structuring the contracts based on the agreement.
- Futures: It is an agreement between two parties which includes a buyer and a seller, wherein lots are traded between the two, through an exchange. Investors can buy interest-rate futures to hedge their risks. These agreements have an expiry date and a delivery date.
- Options: These are contracts akin to futures with the underlying security, but an option is a debt obligation. These instruments mitigate the risk against the parties involved in a floating rate loan. The contracts can have both caps and floors as per the investors’ preference.
- Swaptions: It is also called a swap option which is simply an option to enter into a swap.
- Caps: It is a ceiling and call option on an interest rate. A caplet (series of caps) is made to protect against a rise in the benchmark interest rate for the issuer.
- Floors: Floors are just opposite to caps. The lender uses a floret (series of floors) to protect against falling rates of an outstanding floating rate loan.
- Collars: The existence of a cap and a floor is known as the collar. The collar is used to manage the interest rate strategy.
3. Use of Currency Derivatives: Currency derivatives can be an effective tool to hedge the risk of currency conversion rate fluctuations. Investors can protect against exchange rate risk by combining currency futures and options. These derivatives are used by entities that have issued dollar-denominated bonds or have borrowed in the international market and hence, exposed to foreign currency risk. But the use of currency derivatives has to factor in the clear understanding of basic risk, which is the divergence between spot and future prices that may move imperfectly, sometimes bringing in additional risk.
Understanding the Risks matter
Understanding the risks involved in fixed-income security allows an investor to understand the exposures they are taking on by investing in different kinds of bonds. It also helps investors decide the type of risk they can take (also referred to as risk appetite). For instance, some investors may be able to take sector risk if a particular sector is expected to provide higher yields.
Frequently Asked Questions (FAQs)
What are fixed-income risks?
Fixed income risk occurs because of volatility in the bond market. Risks affect the value of the investment when sold, the investment’s cash flow is affected when it is held, and extra income is gained from the reinvestment of cash flows.
Why is it essential to know the risks of fixed-income securities?
By knowing the risks associated with fixed-income securities, investors can make better decisions and avoid a specific risk based on their risk appetite.
Is fixed-income securities an excellent option to invest in 2023?
Fixed-income securities are an excellent place to park your funds if you want to diversify the risk of equities or if you are a conservative investor with less risk appetite.