What Is Fixed Income?
In general, investment securities that offer fixed interest or dividend payments to investors until their maturity date are referred to as having fixed income. Investors receive their principal investment back when the investment reaches maturity. Bonds issued by governments and corporations are the most popular fixed-income vehicles.
Unlike equity investments, which may not provide cash flows to investors, or variable-income securities, whose payments can fluctuate depending on some underlying factor, such as short-term interest rates, a fixed-income security’s payments are predetermined and will not alter over time.
Investors have access to a number of fixed-income exchange-traded funds (ETFs) and mutual funds in addition to buying fixed-income assets directly.
Understanding Fixed Income
Debt securities are sold by businesses and governments to raise funds for ongoing expenses and major initiatives. Fixed-income securities reward investors with a predetermined interest rate in return for lending their money. Investors receive their capital, or initial investment, back at the maturity date.
For example, a company might issue a 5% bond with a $1,000 face or par value that matures in five years. The investor buys the bond for $1,000 and will not be paid back until the end of the five years. Over the course of the five years, the company pays interest payments—called coupon payments—based on a rate of 5% per year. As a result, the investor is paid $50 per year for five years. At the end of the five years, the investor is repaid the $1,000 invested initially on the maturity date. Investors may also find fixed-income investments that pay coupon payments monthly, quarterly, or semiannually.
For cautious investors looking for a well-diversified portfolio, fixed-income assets are advised. Depending on the investor’s investment approach, the percentage of the portfolio allocated to fixed income will vary. A portfolio that has a mix of equities and fixed-income securities might be diversified to have 50% of its assets in stocks and the remaining 50% in fixed-income securities.
Treasury bonds and bills, municipal bonds, corporate bonds, and certificates of deposit (CDs) are all examples of fixed-income products. Bonds trade over-the-counter (OTC) on the bond market and secondary market.
Types of Fixed Income Products
A government or business bond is the most typical example of a fixed-income asset, as was previously mentioned. The most popular types of government securities are those issued by the United States government, sometimes known as Treasury securities. Governments and businesses outside the United States also sell fixed-income securities.
Here are the most common types of fixed income products:
T-bills are short-term fixed-income securities with one-year maturities that do not offer coupon returns. Investors earn the difference when the bill matures by purchasing it for less than its face value.
Treasury notes (T-notes) are sold in multiples of $100 and have maturities ranging from two to ten years. They also have a fixed interest rate. Investors receive their principal back at maturity but continue to receive semi-annual interest payments.
T-bonds, which have a 20- or 30-year maturity, are comparable to T-notes in many ways. Multiples of $100 can be used to acquire Treasury bonds.
Investors are shielded against inflation via Treasury Inflation-Protected Securities (TIPS). A TIPS bond’s principal amount changes in response to inflation and deflation.
A municipal bond is similar to a Treasury because both are government-issued, but instead of the federal government, a state, municipality, or county issues and backs them. Municipal bonds are used to raise money to pay for local expenses. Investors may gain from municipal bonds in terms of tax exemption.
There are numerous forms of corporate bonds, and the cost and interest rate are mostly determined by the creditworthiness and financial health of the issuer. Better-rated bonds often have lower coupon rates.
High-yield bonds, commonly known as junk bonds, are corporate issuance that pay a larger coupon due to the greater default risk. A corporation enters into default when it doesn’t repay the principle and interest on a bond or other debt obligation.
A certificate of deposit (CD) is a fixed income product with a maturity of fewer than five years that financial institutions offer. The interest rate is higher than that of a standard savings account, and CDs are insured by the FDIC or the National Credit Union Administration (NCUA).
How to Invest in Fixed Income
Investors have a variety of alternatives when deciding how to add fixed-income assets to their portfolios. Most brokers today provide direct access to a variety of bond markets, including Treasuries, corporate bonds, and municipal bonds. Bond funds offer exposure to a variety of bonds and debt instruments for those who do not want to choose individual bonds. These funds give investors access to an income stream through expert portfolio management. While fixed income ETFs function similarly to mutual funds, they may be more affordable and more accessible to individual investors. These ETFs could have certain durations, credit ratings, or other objectives. ETFs are also charged for expert management.
Fixed-income investment is often a conservative strategy where profits are derived from predictable interest-paying low-risk instruments. The interest coupon payments are often smaller because the risk is lower. Bonds, bond mutual funds, and certificates of deposit can all be included in a fixed income portfolio (CDs). The laddering strategy is one such fixed income product-based technique.
When using a laddering approach, you can invest in a number of short-term bonds and receive consistent interest income. The portfolio manager extends the ladder of short-term bonds by reinvesting the refunded principal as bonds mature. By using this technique, the investor is able to acquire ready funds without missing out on the rising market interest rates.
A $60,000 investment, for instance, may be split up into bonds with terms of one year, two years, and three years. The principle is divided into three equal parts of $60,000 by the investor, who puts $20,000 into each of the three bonds. The $20,000 principal will be rolled over into a bond with a one-year maturity following the original three-year holding when the one-year bond matures. The proceeds roll into a bond that extends the ladder by another year when the second bond matures. The investor benefits from a consistent return on interest income and is able to take advantage of any increases in interest rates.
Advantages of Fixed Income
Fixed-income investments give investors a consistent income stream throughout the course of the bond’s or debt instrument’s life while also giving the issuer access to capital or money that is desperately needed. These products are common in retirement portfolios because steady income enables investors to manage their spending.
Relatively Less Volatile
Investment portfolio risk, commonly referred to as market risk, can be stabilized by investors with the use of interest payments from fixed-income instruments. Prices for equities held by investors might change, resulting in significant gains or losses. Fixed-income products’ consistent and reliable interest payments might help offset some of the losses brought on by falling equity values. As a result, these secure investments aid in spreading out an investment portfolio’s risk.
Also, the U.S. government provides support for fixed-income investments in the form of Treasury bonds (also known as T-bonds).
While not guaranteed, corporate bonds are supported by the strength of the underlying business. Bondholders have a greater claim on the company’s assets in the event of bankruptcy or liquidation than do common shareholders.
Furthermore, the Securities Investor Protection Corporation (SIPC) provides up to $500,000 in coverage for the firm’s cash and securities for bond assets maintained at brokerage companies. Fixed income CDs are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per person.
Risks Associated With Fixed Income
Like with other investments, fixed income products have many advantages, but there are also a number of risks that buyers should be aware of.
Credit and Default Risk
As previously indicated, the government and FDIC provide security for Treasuries and CDs.
While being less safe, corporate debt is nevertheless more likely to be repaid than equity held by shareholders. Consider the bond’s and the underlying company’s credit ratings while making your investing decision. Bonds with ratings below BBB are regarded as junk bonds since they are of low quality.
The valuations of the fixed-income instrument prior to maturity might be affected in a variety of ways by the credit risk associated with a firm. Bond prices for a struggling corporation may decrease in value on the secondary market. A bond issued by a faltering corporation may not sell for its face value or par value if an investor tries to sell it. Due to a lack of demand, it could also be challenging for investors to sell the bond on the open market at a fair price or at all.
Over the course of a bond’s existence, prices may rise and fall. The price changes are unimportant if the investor maintains the bond until it matures because they will be compensated with the face value of the bond. Nonetheless, the investor will get paid the current market value at the time of the sale if the bondholder sells the bond through a broker or financial institution before its maturity. Depending on the underlying company, the coupon interest rate, and the current market interest rate, the selling price could result in a gain or loss on the investment.
Interest Rate Risk
Investors in fixed income could be exposed to interest rate risk. This risk arises when the bond’s rate of interest payment lags behind market interest rates, which are growing. The bond would become less valuable in this situation in the secondary bond market. However, because of the investment’s linkage to the investor’s cash, they are unable to use it to make additional money without first suffering a loss.
For instance, the investor would be locked in at 2.5% if they had bought a two-year bond earning 2.5% per year at a time when interest rates on 2-year bonds had increased to 5%. Regardless of the direction interest rates take in the market, investors holding fixed-income securities receive their fixed rate, for better or worse.
Another risk that affects fixed-income investors is inflationary risk. Inflation is a term used to describe the rate at which prices grow in an economy. Gains from fixed-income securities are reduced if prices increase or inflation rises. For instance, the investor loses out and only receives a 0.5% return in real terms if a fixed-rate debt security pays a 2% return and inflation increases by 1.5%.
Fixed Income Analysis: What to Consider
Investors conduct fixed income research before choosing which of these financial products to invest in. The methods listed below are used to assess which investments make the most sense given the investor’s expected returns and risk tolerance.
Risk is frequently where fixed income analysis starts. All investments have a link between their risk and return; generally speaking, a riskier investment should have larger returns. Consequently, fixed income analysis determines if the level of risk an investor is taking on is appropriate for the return on a fixed income security in addition to determining whether the investor is comfortable with the level of risk they are taking on.
Risk for fixed income instruments is correlated with the issuer’s creditworthiness, the maturity of the asset, and the sector in which the company operates. The U.S. government, for instance, frequently has the lowest return fixed income instruments. American bonds are frequently regarded as safer investment options due to the low chance of default. Corporations, on the other hand, particularly those with cash flow issues, may pose a bigger risk.
Periodic payments are offered by several fixed-income instruments. Due to this, investors might recover their money during the course of the investment. While not all cash must be returned at the conclusion of a possibly lengthy bond term, this also lowers risk.
Last but not least, certain fixed income instruments have unique characteristics that make them more or less desirable. Certain bonds might be callable, allowing the debtor to pay back the entire bond before it matures. Other enables the conversion of the fixed income security into ordinary stock. It’s crucial to think about the aspects that are most significant to you because each favorable word will probably lower yield.
Example of Fixed Income
To illustrate, let’s say PepsiCo (PEP) issues fixed-rate bonds for a new bottling plant in Argentina. The issued 5% bond is available at face value of $1,000 each and is due to mature in five years. The company plans to use proceeds from the new plant to repay the debt.
You purchase 10 bonds costing a total of $10,000 and will receive $500 in interest payments each year for five years (0.05 x $10,000 = $500). The interest amount is fixed and gives you a steady income. The company receives the $10,000 and uses the funds to build the overseas plant. Upon maturity in five years, the company pays back the principal amount of $10,000 to the investor who earned a total of $2,500 in interest over the five years ($500 x five years).
What Are Examples of Fixed-Income Securities?
Debt instruments with a fixed rate of interest are known as fixed-income securities. They can include commercial paper, CDs, money market funds, and bonds issued by corporations or governments. Since preferred stock is a hybrid investment that combines characteristics of both debt and equity, it is occasionally regarded as a fixed-income asset as well.
What Is the Difference Between Fixed-Income and Equity Securities?
Fixed-income securities are debt obligations that refund the principal amount to investors at maturity along with interest payments to investors. On the other hand, equity, which is not a loan but rather a residual ownership stake in the company, is issued in the form of company stock. While it might pay a dividend, equity does not have a set maturity date and does not guarantee payments to investors. In general, a company’s equity is a higher-risk/higher-return investment than its bonds.
How Does Inflation Affect Fixed Income?
When inflation raises interest rates, it frequently has a detrimental impact on the value of fixed-income instruments. This is due to the negative correlation between the values of bonds and other fixed-income products and fluctuations in interest rates.
What Is a Fixed Rate vs. Variable Rate Bond?
Bonds with a fixed interest rate are paid at the same rate till maturity. They can be compared to floating or variable rate bonds, which recalculate the interest rate paid on a regular basis in accordance with market rates.
The Bottom Line
Debt investments with fixed interest rates and principal repayments at maturity are referred to as fixed income. Bonds and certificates of deposit fall under this category. As an asset type, fixed income is typically more cautious and less volatile than equity (stocks). Fixed income should make up a portion of a well-diversified portfolio, and that portion should grow as one’s time horizon shrinks (e.g. as retirement approaches).