Price fluctuations in fixed income - 11/21/2021 - Marcia Dessen

A fixed income security represents a credit transaction between two parties. At one end, the investor, willing to lend money for a previously negotiated term and remuneration.

At the other end, the borrower of funds issues a bond that represents their debt to the investor, the promise of returning the capital plus interest on the maturity date.

Thus, the investor’s main risk is the credit risk, guaranteed by the FGC in the case of bonds issued by a financial institution, as I discussed in “Credit risk in fixed income”.

And this may be the only risk for those who invest with the intention of holding the security until maturity. In this case, the investor knows exactly when and how much he will earn, and the name “fixed income” applies perfectly.

However, if the investor needs liquidity and wants to sell the security before maturity, he will be exposed to market risk, that is, price fluctuation, which can rise or fall depending on the term and rate that corrects the operation. That’s when he discovers that not everything is fixed in fixed income.

The investor chooses how he wants to remunerate his capital. The most conservative option, suitable for those who need liquidity and do not want to expose themselves to market risk, is the post-fixed rate, which follows the Selic or CDI variation. It is called that way because the investor only knows the profitability, in absolute terms, on the redemption of the operation.

The liquidity attribute is inherent to some securities, such as the Treasury Bill (or Treasury Selic) and the CDB DI; the investor can redeem at any time, without fright. LCI and LCA, for example, require a grace period. Others, such as debentures, CRI and CRA, are exposed to market risk.

Investors who opt for fixed rate or inflation-linked securities know how much they will earn at maturity. Resale before the deadline exposes the investor to market risk.

The fixed rate, negotiated on the day of purchase, is subject to the capital remaining until maturity. Whoever buys a Prefixed Treasury or CDB at 10% per year, for example, maturing on January 1, 26, will receive on that date the capital adjusted by the contracted rate.

The investor who sells the security in advance breaks this condition and submits to accept the price dictated by the market, which can generate greater or lesser returns than that traded.
“Can I lose money, sell for less than I invested?”

Yes. If the interest rate rises to 12% per year, for example, this will be the return required by the new investor. The security’s redemption value will be discounted at the new rate, for the period to elapse until maturity.

When the resale rate (12%) is higher than initially contracted (10%), the profitability of the period elapsed may be negative or lower than expected. The longer the period that elapses, the greater the risk.

The same concept applies to bonds that pay IPCA plus a fixed interest rate. The IPCA variation will always be positive, but the fixed-rate component can cause an important change in the security’s value before maturity, especially in longer bonds.

How do investors protect their capital? In the case of credit risk, by diversifying issuers and investing in FGC-backed securities. In the case of market risk, opting for shorter bonds and diversifying the types of rates. Liquidity risk, keeping part of the capital in post-fixed rate liquid assets.

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