FAQs about Interest Rate Securities

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What are Interest Rate Securities?

An Interest Rate Security is a debt security (sometimes called a bond). When you buy or subscribe for an Interest Rate Security, you are lending money to a government, corporation or other entity, known as the issuer. In return for the loan, the issuer usually promises to pay you a specified rate of interest (a coupon) during the life of the Interest Rate Security and to repay the face value of the Interest Rate Security (the principal) when it falls due or "matures".

The types of Interest Rate Securities you can choose from include:

  • Commonwealth Government securities;
  • Semi Government securities;
  • Corporate Interest Rate Securities.
  • Structured Credit Products

What are the sorts of questions I should ask about an Interest Rate Security?

  • What is the maturity?
  • Does it have early redemption features (e.g. a call date)?
  • What is the credit quality? What is the rating?
  • What is the coupon?
  • What is the price?
  • What is the yield to maturity?
  • Who is the issuer?

What is the Maturity of an Interest Rate Security?

One of the key features of any Interest Rate Security is its maturity. The maturity tells you when you should expect to get your principal back and how long you can expect to receive interest payments. (It is important to note that some interest rate securities issued by corporates have "call", or redemption, features that can affect the date when your principal is returned). Perpetuals are securities without a maturity to date.

What are Perpetual Securities?

‘Perpetuals’ are Interest Rate Securities without a maturity date. Investors get their money back when they sell the securities in the secondary market. Therefore, in assessing whether to buy perpetuals, investors should take into account the potential liquidity risk. That is ‘what will be the likely ability to sell these securities in the secondary market in the future’.

Typically perpetuals pay a floating rate of interest and often have a call provision.

What are Floating Rate Securities?

Also called floating rate notes (FRN’s), these securities pay a variable rather than a fixed coupon. This floating coupon is usually adjusted in line with movements in an underlying benchmark. For example the 90 day bank bill rate.

What is a Call?

If the interest rate security contains a "call" provision, the issuer usually retains the right to redeem (pay back) the debt, in full or in part, before the stated maturity date.

A call feature creates uncertainty as to whether the Interest Rate Security will remain on issue until its maturity date. Investors risk losing an interest rate security paying a higher rate of interest if market rates fall and issuers decide to call in their Interest Rate Securities.

Because a call feature puts the investor at a disadvantage, callable Interest Rate Securities normally offer higher yields than otherwise would be the case.

What are Credit Ratings?

The ability of an issuer to meet its commitment to pay all promised interest and principal amounts in full and on time is of critical importance to investors. Most corporate Interest Rate Securities are evaluated for credit quality by agencies such as Standard & Poor's and Moody's Investors Service. (Their rating systems are listed in the table below) It is normally considered prudent to check the rating of Interest Rate Securities before buying them. Such details can normally be obtained through a broker or financial adviser.

Interest Rate Securities rated BBB or higher by Standard & Poor's, and Baa or higher by Moody's, are widely considered to be of "investment grade." This means the quality of the securities is normally considered high enough for a prudent investor to purchase them.

Credit Risk Moody’s Standard
& Poor’s
Investment Grade
Highest quality Aaa AAA
High quality (very strong) Aa AA
Upper medium grade (strong) A A
Medium grade Baa BBB
Not Investment Grade
Lower medium grade (somewhat speculative) Ba BB
Low grade (speculative) B B
Poor quality (may default) Caa CCC
Most speculative Ca CC
No interest being paid or bankruptcy petition filed C C
In default C D

Some Interest Rate Securities are not rated, but this does not necessarily mean they are unsafe for investors. Before buying such a security, however, it is considered prudent to ask a financial adviser for other evidence of its quality.

What are Coupons?

A coupon refers to the interest rate paid to the holder of an Interest Rate Security. Coupons can be fixed, floating or payable at maturity. Most debt securities traditionally have a coupon that is fixed until maturity, is a percentage of the face (principal) amount, and pay interest semiannually. For example, a $10,000 Interest Rate Security with an 5% p.a. coupon will pay investors $500 a year, in payments of $250 every six months. When the Interest Rate Security matures, investors receive the full face amount of the security (in this example, $10,000).

Some issuers and investors prefer having a coupon that periodically adjusts, and more closely tracks prevailing market rates. The coupon on a floating-rate Interest Rate Security is reset periodically in line with changes in a base interest-rate index, such as the rate on 90 day Bank Bills.

What factors normally determine the price of an Interest Rate Security?

The price you pay for an Interest Rate Security is based on a variety of factors, such as prevailing market interest rates, credit quality, maturity terms and tax status. Newly issued interest rate securities normally sell at or close to their face value. Prices of interest rate securities traded in the secondary market, however, fluctuate in response to changing interest rates. When the price of a interest rate security increases above its face value, it is said to be selling at a premium. When a interest rate security sells below face value, it is said to be selling at a discount.

Investors should be aware that some of the price movements will be due to the amount of interest accruing (accrued interest) on the securities each day.

What are the components of the "Purchase Price" of an Interest Rate Security?

The purchase price (also known as the gross price) is the total amount that an investor pays for a bond. Purchase price comprises the number of bonds that an investor buys times the price paid for a bond.

The purchase price includes two components:

  • Capital Price which is the price of the bond as estimated by the market based on a number of variables including interest rates, maturity date, status and credit quality.
  • Accrued Interest on the bond which is the amount of interest accumulated on a bond since the last coupon payment. Because interest is paid at regular intervals the bond price increases daily by the amount of interest accruing. On a 6.50 per cent annual coupon, interest accrues at 1.78 cents per $100 per day. Immediately following the coupon payment the price will fall by the amount of that coupon payment.

The gross price of a bond is determined by adding any accrued interest to its capital price.

What is a Yield?

The Yield on an Interest Rate Security is the return you earn based on the price you paid and the interest payments you expect to receive. There are two main types of interest rate security yields:

  • current yield; and
  • yield to maturity.

Current yield is the annual return on the dollar amount paid for the Interest Rate Security and can be worked out by dividing the coupon payment by the purchase price. If a security with a face value of $10,000 was bought for $10,000 and the coupon is 5% ($500), the current yield is 5% ($500 divided by $10,000). If you buy the same security for $9000 and the coupon is 5% ($500), the current yield is 5.5% ($500 divided by $9000).

Yield to maturity, which is considered more meaningful, shows the total return that is expected by holding the Interest Rate Security until it matures (if there is a call, a modified formula, known as yield to call, tells you the total return that would be earned if held to the first call date). It also enables you to compare Interest Rate Securities with different maturities and coupons. Yield to maturity encapsulates all the coupons to be received from the time the Interest Rate Security is purchased until maturity (including interest on interest at the original purchasing yield), plus any gain (if the interest rate security is bought below its face value) or loss (if the security is bought above its face value).

What are High-Yield Interest Rate Securities?

Interest rate securities with a credit rating of BB (Standard & Poor's) or Ba (Moody's) or below are speculative investments. They are usually called high-yield Interest Rate Securities (or junk bonds). They pay higher coupons than investment grade interest rate securities in an attempt to compensate for the extra risk.

What is the relationship between Price and Yield?

The day-to-day price of an interest rate security will fluctuate according to both market and company-specific factors, such as changes in market conditions and credit quality. Changes in the market level of interest rates will normally have an immediate, and predictable, effect on the prices of Interest Rate Securities already on issue.

When market interest rates rise, prices of existing interest rate securities on issue (those with fixed coupons) fall to bring the yield of older Interest Rate Securities into line with new issues offering the higher interest rates. Conversely, when market interest rates fall, prices of existing Interest Rate Securities rise, until the yield of older Interest Rate Securities is low enough to match the new issues offering the lower interest rates.

Because of these fluctuations, it will often be the case that the value of an Interest Rate security will likely be higher or lower than its original face value if it is sold before it matures.

What is the relationship between interest rates and maturity?

Changes in market interest rates can have differing impacts for different Interest Rate Securities. The longer the time to maturity date, the greater the risk that prices will fluctuate before that date and that the fluctuations will be greater, and the more that holders will need to be compensated for taking extra risk. As such, there is a direct link between maturity and yield. It can best be seen by drawing a line between the yields available on like securities of different maturities, from shortest to longest. Such a line is called a yield curve.

The yield curve can highlight market expectations regarding future interest rates. A normal yield curve shows a fairly steep rise in yields between short and intermediate term issues and a less pronounced rise between intermediate and long term issues. That is because the longer an investor's money is at risk the more he or she will expect to earn.

What is Event Risk?

In recent years, many corporate issuers have tried to increase shareholder value by undertaking various corporate actions (such as mergers and recapitalisations). Such events can result in a greater proportion of debt for these issuers, and consequently a fall in the value of Interest Rate Securities already on issue by them (due to a higher credit risk). While some corporate issuers offer protection to holders of interest rate securities (e.g. bond covenants that restrict further borrowings), these are by no means fully effective. An individual investor should see, or ask his or her adviser, if the rating agencies have written commentaries on a company's vulnerability to event risk before buying its interest rate securities.