What is a Fixed-Rate Bond?
A fixed-rate bond is a type of debt instrument that pays a fixed coupon or interest rate throughout its course of maturity. Dissimilar to a floating rate note, a fixed rate bond is a long term, fixed-income security that carries a predetermined interest rate.
Due to its fixed nature, the fixed-rate bond is not susceptible to fluctuations in interest rates, and is therefore viewed as a security that does not possess a significant amount of interest rate risk. That being said, the fixed-rate bond, although a conservative investment, is highly susceptible to a loss in value due to inflation. The fixed-rate bond’s long maturity schedule and predetermined coupon rate offers an investor a solidified return, while leaving the individual exposed to a rise in the consumer price index and overall decrease in their purchasing power.
The coupon rate attached to the fixed-rate bond is payable at specified dates before the bond reaches maturity; the coupon rate and the fixed-payments are delivered periodically to the investor at a percentage rate of the bond’s face value. Due to a fixed-rate bond’s lengthy maturity date, these payments are typically small and as stated before are not tied into interest rates.
Any fixed-income instrument that contains a long maturity schedule (such as a treasury bond) will increase the holder’s risk of inflation. Over time the purchasing power of a dollar decreases as the general prices for goods rises. Because the holder of the bond is locked into a fixed rate, there is no adjustment made for inflation or interest rates, leaving the holder stuck with a weakened payment. For example, a dollar was worth more 20 years ago, meaning those who have held a fixed-rate bond for 20 years are experiencing diminished returns (in regards to purchasing power) when compared to what they were receiving during the infancy of their investment.
Dissimilar to a fixed-rate bond, a floating rate note is a type of bond that contains a variable coupon that is equal to a money market reference rate, or a federal funds rate plus a specified spread. Although the spread remains constant, the majority of floating rate notes contains quarterly coupons that pay-out interest every 3 months with variable percentage returns. At the beginning of each coupon period, the rate is calculated by adding the spread with the reference rate. This structure differs from the fixed-bond rate which locks in a coupon rate and delivers it to the holder over semi-annually over a course of multiple years.