Introduction
A type of bond which bears interest is known as an income bond. This bond pays a fixed rate of interest to the investor, usually on an annual basis, until the bond matures. Upside potential of these bonds is limited, precluding participation in the capital appreciation of the underlying asset, but income bonds feature solid downside protection for the investor.
Types of Income Bonds
There are two main types of income bonds: Fixed Rate Income Bonds and Floating Rate Income Bonds. Fixed rate income bonds offer a fixed rate of return throughout the life of the bond so investors can be guaranteed a fixed rate interest payment on a specific date. Floating rate income bonds offer a variable coupon structure, and reset periodically based on the underlying market rate. Investors can earn higher returns with this type of bond, but bear the risk of lower coupon payments should market rates be lower.
Risk
The main risk associated with income bonds is the risk of default on the interest payment. If either the issuer or the intermediary fails to make the appropriate payment, the investor may not receive the full amount of interest anticipated. If a company is in a weak financial state, its bonds may lose value in the market and that may indicate the need for the issuer to default on its payments. Another downside to owning income bonds is that their value does not increase when other financial assets do. The fixed interest rate could result in uneven returns compared to alternative investments.
Issuance
When income bonds are issued, information about the bonds is provided to investors. This information should include the issuer and the intermediary, details of the coupon rate, redemption terms and repayment terms. In cases where a floating rate income bond is issued, more information should be provided to investors including the margin between the coupon rate and the underlying bond, details of how often the coupon rate is reset, and any special features that could affect the current or future payments.
Advantages
Income Bonds provide investors with a stream of interest payments, specifically for investors looking for a steady source of income. The coupon payments tend to be higher than other fixed income securities such as government bonds, and their appeal is that they have greater predictability of payments. Investors have some assurance of safety as long as the underlying issuer is financially sound and unlikely to default.
Disadvantages
Although income bonds are more attractive to investors than other types of bonds, they do have their drawbacks. Some investors may find that the interest rate paid on the bonds is too low in comparison to other investments. Also, income bonds do not allow investors to take advantage of capital gains if asset prices rise, as with traditional equity investments. Moreover, investors are exposed to credit risk, and may not get back the principal amount if the issuer defaults on interest payments.
Conclusion
Income bonds are often deemed as a safer investment than other bonds and securities, as they provide investors with a steady source of income. As long as the issuer of the bond is financially sound and paying the coupon payments, investors are protected from losses due to changes in interest rates, or the value of the asset in the underlying market. Income bonds provide solid downside protection for investors, but does not offer any upside potential other than from the fixed rate of interest paid. Investors should ensure they understand the terms of the bond before investing, and consider other investments that may offer better returns with lower risk.
