Fixed income broadly refers to those types of investment security that pay
investors fixed interest or dividend payments until their maturity date. At
maturity, investors are repaid the principal amount they had invested. Government
and corporate bonds are the most common types of fixed-income products.
Unlike equities that may pay out no cash flows to investors, or variable-income
securities, where payments can change based on some underlying measure—such
as short-term interest rates—the payments of a fixed-income security are known in
advance and remain fixed throughout.
In addition to purchasing fixed-income securities directly, there are several fixed income exchange-traded funds (ETFs) and mutual funds available to investors.
Companies and governments issue debt securities to raise money to fund day-today operations and finance large projects. For investors, fixed-income instruments
pay a set interest rate return in exchange for investors lending their money. At the
maturity date, investors are repaid the original amount they had invested—known
as the principal.
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.
Fixed-income securities are recommended for conservative investors seeking a
diversified portfolio. The percentage of the portfolio dedicated to fixed income
depends on the investor’s investment style. There is also an opportunity to
diversify the portfolio with a mix of fixed-income products and stocks creating a
portfolio that might have 50% in fixed-income products and 50% in stocks.
Treasury bonds and bills, municipal bonds, corporate bonds, and certificates of
deposit (CDs) are all examples of fixed-income products. Bonds trade over-thecounter (OTC) on the bond market and secondary market.
Fixed Income Pros and Cons.
Pros
Steady income stream of fixed returns.
More stable returns than stocks.
Higher claim to the assets in bankruptcies.
Government and FDIC backing on some.
Cons
Returns are often lower than other investments.
Credit and default risk exposure.
Susceptible to interest rate risk.
Sensitive to Inflationary risk.
Types of Fixed Income Products.
As stated earlier, the most common example of a fixed-income security is a
government or corporate bond. The most common government securities are those
issued by the U.S. government and are generally referred to as Treasury securities.
Fixed-income securities are offered by non-U.S. governments and corporations as
well.
Here are the most common types of fixed income products:
Treasury bills (T-bills) are short-term fixed-income securities that mature
within one year that do not pay coupon returns. Investors buy the bill at a
price less than its face value and investors earn that difference at maturity.
Treasury notes (T-notes) come in maturities between two and 10 years,
pay a fixed interest rate, and are sold in multiples of ₹100. At the end of
maturity, investors are repaid the principal but earn semiannual interest
payments until maturity.
Treasury bonds (T-bonds) are similar to the T-note except that it matures
in 20 or 30 years. Treasury bonds can be purchased in multiples of ₹100.
Treasury Inflation-Protected Securities (TIPS) protect investors from
inflation. The principal amount of a TIPS bond adjusts with inflation and
deflation.
A municipal bond is similar to a Treasury since it is government-issued,
except it is issued and backed by a state, municipality, or county, instead of
the federal government, and is used to raise capital to finance local
expenditures. Muni bonds can have tax-free benefits to investors as well.
Corporate bonds come in various types, and the price and interest rate
offered largely depend on the company’s financial stability and its
creditworthiness. Bonds with higher credit ratings typically pay lower
coupon rates.
Junk bonds—also called high-yield bonds—are corporate issues that pay a
greater coupon due to the higher risk of default. Default is when a company
fails to pay back the principal and interest on a bond or debt security.
A certificate of deposit (CD) is a fixed income vehicle offered by financial
institutions with maturities of less than five years. The rate is higher than a
typical saving account, and CDs carry FDIC or National Credit Union
Administration (NCUA) protection.
How to Invest in Fixed Income.
Investors looking to add fixed-income securities to their portfolios have several
options. Today, most brokers offer customers direct access to a range of bond
markets from Treasuries to corporate bonds to munis. For those who do not want
to select individual bonds, Fixed-income mutual funds (bond funds) give exposure
to various bonds and debt instruments. These funds allow the investor to have an
income stream with the professional management of the portfolio. Fixed income
ETFs work much like a mutual fund, but may be more accessible and more cost effective to individual investors. These ETFs may target specific credit ratings,
durations, or other factors. ETFs also carry a professional management expense.
Fixed-income investing is generally a conservative strategy where returns are
generated from low-risk securities that pay predictable interest. Since the risk is
lower, the interest coupon payments are also, usually, lower as well. Building a
fixed income portfolio may include investing in bonds, bond mutual funds, and
certificates of deposit (CDs). One such strategy using fixed income products is
called the laddering strategy.
A laddering strategy offers steady interest income through the investment in a
series of short-term bonds. As bonds mature, the portfolio manager reinvests the
returned principal into new short-term bonds extending the ladder. This method
allows the investor to have access to ready capital and avoid losing out on rising
market interest rates.
For example, a $60,000 investment could be divided into one-year, two-year, and
three-year bonds. The investor divides the ₹60,000 principle into three equal
portions, investing ₹20,000 into each of the three bonds. When the one-year bond
matures, the ₹20,000 principal will be rolled into a bond maturing one year after
the original three-year holding. When the second bond matures those funds roll
into a bond that extends the ladder for another year. In this way, the investor has a
steady return of interest income and can take advantage of any higher interest
rates.
Advantages of Fixed Income
Income Generation
Fixed-income investments offer investors a steady stream of income over the life
of the bond or debt instrument while simultaneously offering the issuer muchneeded access to capital or money. Steady income lets investors plan for spending,
a reason these are popular products in retirement portfolios.
Relatively Less Volatile.
The interest payments from fixed-income products can also help investors
stabilize the risk-return in their investment portfolio—known as the market risk.
For investors holding stocks, prices can fluctuate resulting in large gains or losses.
The steady and stable interest payments from fixed-income products can partly
offset losses from the decline in stock prices. As a result, these safe investments
help to diversify the risk of an investment portfolio.
Risks Associated With Fixed Income.
Although there are many benefits to fixed income products, as with all
investments, there are several risks investors should be aware of before purchasing
them.
Credit and Default Risk
As mentioned earlier, Treasuries and CDs have protection through the government
and FDIC.6 Corporate debt, while less secure still ranks higher for repayment than
do shareholders. When choosing an investment take care to look at the
credit rating of the bond and the underlying company. Bonds with ratings below
BBB are of low quality and consider junk bonds.
The credit risk linked to a corporation can have varying effects on the valuations
of the fixed-income instrument leading up to its maturity. If a company is
struggling, the prices of its bonds on the secondary market might decline in value.
If an investor tries to sell a bond of a struggling company, the bond might sell for
less than the face or par value. Also, the bond may become difficult for investors
to sell in the open market at a fair price or at all because there’s no demand for it.
The prices of bonds can increase and decrease over the life of the bond. If the
investor holds the bond until its maturity, the price movements are immaterial
since the investor will be paid the face value of the bond upon maturity. However,
if the bondholder sells the bond before its maturity through a broker or financial
institution, the investor will receive the current market price at the time of the sale.
The selling price could result in a gain or loss on the investment depending on the
underlying corporation, the coupon interest rate, and the current market interest
rate.
Interest Rate Risk
Fixed-income investors might face interest rate risk. This risk happens in an
environment where market interest rates are rising, and the rate paid by the bond
falls behind. In this case, the bond would lose value in the secondary bond market.
Also, the investor’s capital is tied up in the investment, and they cannot put it to
work earning higher income without taking an initial loss.
For example, if an investor purchased a two-year bond paying 2.5% per year and
interest rates for 2-year bonds jumped to 5%, the investor is locked in at 2.5%. For
better or worse, investors holding fixed-income products receive their fixed rate
regardless of where interest rates move in the market.
Inflationary Risks
Inflationary risk is also a danger to fixed-income investors. The pace at which
prices rise in the economy is called inflation. If prices rise or inflation increases, it
eats into the gains of fixed-income securities. For example, if fixed-rate debt
security pays a 2% return and inflation rises by 1.5%, the investor loses out,
earning only a 0.5% return in real terms