Guide to fixed income investments

Fixed income is an asset class favored for their low volatility and stable returns compared to other investments. Fixed income investments provide can return higher yields than standard interest-bearing savings accounts, making the asset class a nice middle ground for investors looking to safely boost income generated from capital.

Most fixed income instruments pay interest in regular payments, like coupon payments for bonds, and return the principal amount at the end of the investment's fixed lifespan. Hence the name fixed income.

Fixed income investors tend to be retirees or other investors who have already accumulated the majority of their life's income and are looking to generate safe, stable returns as a new income stream.

• What is fixed income

• Fixed income vs growth-oriented investments

• Benefits of fixed income investing

• Risks of fixed income investing

• Types of fixed income securities

• How to invest in fixed income

What is fixed income investing

Fixed income investing is a form of debt investing, in which an investor lends capital to an issuer, who pays regular interest amounts throughout the loan's lifetime before returning the entire amount at the end of the contract once the maturity date is reached.

Fixed income investments differ depending on the issuer, contract length, interest rate, and credit worthiness. Fixed income securities are generally seen as less risky than other forms of investment, but their yields are often less profitable in comparison.

Fixed income investment example

Consider a 10-year bond with a face value of $10,000 and an annual interest rate of 4%. As a fixed income investment, this bond will pay $400 in interest each year (4% of $10,000). These interest payments, known as coupon payments, are typically made semi-annually or annually (either two payments of $200 or one payment of $400 per year). Over the bond's 10-year term, the investor will receive a total of $4,000 in interest payments. At the maturity date, the investor will also get back the principal amount of $10,000.

 Fixed income vs growth-oriented investments

Fixed income investments are considered safer than growth-oriented investments like stocks, real estate, and derivatives. Although, the tradeoff for a safer investment means fixed income investments often have lower returns than those with higher risk.

Investors typically utilize both fixed-income and growth-oriented investments in an investment portfolio to balance risk and ensure regular returns. The ratio of fixed income to growth-oriented investments will generally lean more heavily on fixed income as investors age.

This allows older investors to generate fixed returns on whatever capital they've accrued with the higher-risk investments made earlier in life. It's also preferably for older investors to become less risk-tolerant because they have less time to recoup potential losses from riskier investments.

Benefits of fixed income investing

Fixed income investments offer several key benefits, making them an attractive component of a diversified investment portfolio. Firstly, they provide predictable and regular income through interest payments, which is particularly beneficial for retirees or those seeking steady cash flow. Secondly, they generally offer lower risk compared to equities, as they prioritize the return of principal and interest payments. This stability is valuable during periods of market volatility or economic downturns.

Additionally, fixed income securities can help diversify an investment portfolio, reducing overall risk. Their performance often inversely correlates with equities, providing a buffer against stock market fluctuations. Moreover, certain fixed income investments, such as government bonds and high-quality corporate bonds, are considered safe havens, preserving capital and offering liquidity. Tax advantages are another benefit, especially with municipal bonds, where interest income can be exempt from federal and state taxes. Overall, fixed income investments balance growth-oriented assets, contributing to a more resilient portfolio.

Risks of fixed income investing

Fixed income investments, such as bonds and certificates of deposit (CDs), are generally considered safer than equities. However, they are not without risks. Understanding these risks is crucial for investors to make informed decisions. There are four main risks associated with fixed income investments: credit risk, inflation risk, interest-rate risk, and market-to-market risk.

Credit risk

Credit risk, also known as default risk, refers to the possibility that the issuer of a fixed income security will be unable to make the required interest payments or repay the principal at maturity. This risk is particularly significant for corporate bonds and municipal bonds, where the financial health of the issuing entity can vary widely.

Credit ratings provided by agencies such as Standard & Poor's, Moody's, and Fitch offer a measure of an issuer's creditworthiness. Securities with lower credit ratings (below investment grade) are considered high-yield or junk bonds and carry higher credit risk. For instance, a company experiencing financial difficulties may default on its bond payments, leading to significant losses for investors.

Investors can mitigate credit risk by diversifying their bond holdings across various issuers, sectors, and credit ratings. Additionally, opting for bonds with higher credit ratings can provide more stability, albeit usually at the cost of lower yields.

Inflation risk

Inflation risk, also known as purchasing power risk, is the danger that the returns on fixed income investments will not keep pace with inflation, leading to a reduction in the purchasing power of the returns. This risk is particularly relevant in long-term bonds where the fixed interest payments may become less valuable over time as prices for goods and services rise.

For example, if an investor holds a bond with a 3% annual yield and the inflation rate rises to 4%, the real return on the bond becomes negative, eroding the value of the investment. Inflation-indexed securities, such as Treasury Inflation-Protected Securities (TIPS), can help mitigate this risk, as their principal value adjusts with inflation.

Investors should be mindful of the current inflation environment and consider diversifying their portfolios with assets that can provide some inflation protection, such as real estate or equities, alongside their fixed income investments.

Interest-rate risk

Interest-rate risk is the risk that changes in prevailing interest rates will affect the value of fixed income securities. When interest rates rise, the price of existing bonds typically falls because new bonds are issued at higher rates, making the old bonds with lower rates less attractive. Conversely, when interest rates fall, existing bonds with higher rates become more valuable.

This risk is more pronounced for long-term bonds compared to short-term bonds because the longer the maturity, the more sensitive the bond’s price is to changes in interest rates. For example, if an investor holds a 10-year bond and interest rates increase significantly, the market value of that bond will decrease more than that of a 2-year bond.

To manage interest-rate risk, investors can ladder their bond portfolios, which involves buying bonds with different maturities. This strategy can help balance the risk since not all bonds will be affected by interest rate changes simultaneously.

Market-to-market risk

Market-to-market risk, also known as price volatility risk, refers to the potential for fluctuations in the market price of fixed income securities. This risk arises because the market price of bonds can change due to various factors, including changes in interest rates, economic conditions, and the creditworthiness of the issuer.

For instance, if a company’s financial situation deteriorates, the market may react by selling off its bonds, causing their prices to drop. Similarly, if interest rates rise, the market value of existing bonds will fall as new bonds offer higher yields.

Investors who need to sell their bonds before maturity may incur losses if the market price is below the purchase price. Holding bonds to maturity can avoid this risk, as the investor will receive the face value of the bond at maturity regardless of market fluctuations. However, this approach limits liquidity.

Types of fixed income securities

Corporate bonds

Corporate bonds are debt securities issued by companies to raise capital for various purposes, such as expanding operations, funding research and development, or refinancing existing debt. These bonds come with a promise to pay periodic interest (coupon payments) and return the principal amount at maturity. Corporate bonds can be categorized based on their credit quality: investment-grade and high-yield (or junk) bonds. Investment-grade bonds have lower credit risk and offer lower yields, while high-yield bonds carry higher risk and provide higher returns. The maturity of corporate bonds can range from short-term (less than five years) to long-term (over ten years). Investors in corporate bonds should assess the issuing company's financial health, industry conditions, and prevailing interest rates to gauge the risk and potential return.

Government bonds

Government bonds, also known as sovereign bonds, are issued by a federal government to finance their expenditures. In the United States, these include Treasury bonds (T-bonds), Treasury notes (T-notes), and Treasury bills (T-bills), each differing in maturity: T-bills have maturities of one year or less, T-notes range from two to ten years, and T-bonds have maturities longer than ten years. Government bonds are considered low-risk investments since they are backed by the full faith and credit of the issuing government. They offer periodic interest payments and are a stable income source, making them attractive during economic uncertainty. Other countries issue similar treasury securities, such as gilts in the UK and JGBs (Japanese Government Bonds) in Japan.

Municipal bonds

Municipal bonds (munis) are issued by state, city, or local governments to fund public projects like schools, highways, and water systems. They are appealing to investors due to their tax-exempt status, meaning the interest income is often exempt from federal, state, and local taxes, especially if the investor resides in the issuing state. Municipal bonds come in two types: general obligation bonds, backed by the issuer's taxing power, and revenue bonds, supported by the revenue generated from specific projects (e.g., toll roads or stadiums). While generally considered safe, the credit risk of these bonds can vary based on the issuer’s financial health and economic conditions in the issuing municipality.

Mutual funds

Fixed income mutual funds pool money from many investors to purchase a diversified portfolio of bonds and other fixed income securities. These funds are managed by professional portfolio managers who select securities based on the fund's investment objectives, such as income generation, preservation of capital, or total return. Mutual funds offer instant diversification, reducing the risk associated with holding individual bonds. They also provide liquidity, as investors can buy or sell shares of the fund on any business day. However, they carry management fees and may be subject to interest rate risk, credit risk, and market fluctuations. Popular categories include short-term, intermediate-term, and long-term bond funds, as well as sector-specific funds like corporate bond funds or government bond funds.

Money market funds

Money market funds are a type of mutual fund that invests in short-term, high-quality debt instruments, such as Treasury bills, commercial paper, and certificates of deposit (CDs). These funds aim to provide investors with liquidity, stability, and a modest yield, making them a popular choice for parking cash or as a safe haven during volatile markets. Money market funds are considered low-risk investments due to their focus on highly rated, short-term securities. They maintain a stable net asset value (NAV) of $1 per share, though this is not guaranteed. The interest rates offered by money market funds are typically higher than savings accounts but lower than longer-term investments.

CDs

CDs are time deposits offered by financial institutions like banks and credit unions that pay a fixed interest rate for a specified term, ranging from a few months to several years. Only fixed income investment protected against loss.

Bank CDs are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor, providing a safe investment option. Investors agree to leave their money in the CD for the term's duration, incurring penalties for early withdrawal.

Brokered CDs, sold through brokerage firms, often offer higher yields and more flexibility in terms of buying and selling before maturity. However, they may come with fees and are subject to market price fluctuations. Both types of CDs are suitable for conservative investors seeking predictable returns and principal protection.

Bond ETFs

Bond ETFs are investment funds traded on stock exchanges that hold a portfolio of bonds and other fixed income securities. They offer the benefits of diversification, professional management, and liquidity, similar to mutual funds, but with the added advantage of intraday trading and typically lower expense ratios. ETFs can focus on various segments of the bond market, including government bonds, corporate bonds, municipal bonds, and high-yield bonds. Investors can use ETFs to gain exposure to specific sectors, maturities, or credit qualities, making them a versatile tool for building a diversified fixed income portfolio. However, they are subject to market risks and can experience price fluctuations.

Other fixed income securities

Beyond traditional types of fixed income securities, there are other options such as preferred stocks, convertible bonds, and mortgage-backed securities (MBS). Preferred stocks pay fixed dividends and have a higher claim on assets than common stocks but are subordinate to bonds. Convertible bonds can be converted into a predetermined number of shares of the issuing company’s stock, offering the potential for capital appreciation along with fixed income characteristics. Mortgage-backed securities are created from pools of mortgages and provide periodic payments derived from homeowners' mortgage payments. Each of these investments carries unique risks and benefits, making them suitable for different investment strategies and risk tolerances. Diversification and careful assessment of each security's risk profile are essential when considering these alternatives.

How to invest in fixed income

There are many ways to incorporate fixed income securities into your portfolio. Brokers like StoneX offer access to a range of bond markets, and mutual bond funds provide exposure to various debt instruments with the purchase of a single security. Fixed income ETFs are even more cost-effective than bonds, allowing investors to hand-pick characteristics like duration and credit-worthiness while also paying for professional management experience.