Fixed Income
What Is Fixed Income?
Fixed income is a type of investment security that pays investors fixed interest payments until its 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. However, there are fixed income exchange-traded funds and mutual funds available.
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.
Fixed Income Explained
Companies and governments issue debt securities to raise money to fund day-to-day operations and finance large projects.
Fixed-income instruments pay investors 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. The company will pay interest for those five years called coupon payments. The amount will depend on the investment made for a particular period which here is five years. As a result, the investor is paid $50 per year for five years. At the end of the five years which is known as maturity; the investor is repaid $1,000 that was invested initially. Investors may also find fixed income investments that return coupon payments monthly, quarterly, or half-yearly.
Key Takeaways
Fixed income is a type of security that pays investors fixed interest payments until its 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
In the event of a company’s bankruptcy, fixed-income investors are paid before common stockholders.
Types Of Fixed Income Products
As stated earlier, the most common example of a fixed-income security is a government or corporate bond.
- Treasury bills (T-bill) are short-term fixed-income securities that mature within one year that do not pay coupon return. Investors buy the bill at a price less than its face value and investors earn that difference at the maturity.
- Treasury notes (T-note) come in maturities between two and 10 years, pay a fixed interest rate, and usually have a $1,000 face value. At the end of the maturity, investors are repaid the principal but earn semiannual payments of interest each year they hold the note.
- The Treasury bond (T-bond) is very similar to the T-note except that it matures in 30 years. Treasury bonds can have face values of $10,000 each.
- 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 Treasury’s but is issued and backed by a state, municipality, or country, and finances capital expenditures. Municipal 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 higher coupons 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 savings account, and CDs carry FDIC or National Credit Union Administration (NCUA) protection.
- Fixed-income mutual funds—such as those offered by Vanguard—invest in various bonds and debt instruments. These funds allow the investor to have an income stream with professional portfolio management. However, they will pay a fee for the convenience.
- Asset-allocation or fixed-income ETFs work much like a mutual fund. These funds target specific credit ratings, durations, or other factors. ETFs also carry a professional management expense.
Fixed Income Investment as a Strategy
Fixed income investing is 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.
Benefits of Fixed Income
Fixed income investments offer investors a steady stream of income over the life of the bond or debt instrument while simultaneously offering the issuer much-needed access to capital or money. Steady income let investors plan for spending, a reason these are popular products in retirement portfolios.
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.
Also, fixed income investments in the form of Treasury bonds (T-bonds) have the backing of the U.S. government. Fixed income CDs have Federal Deposit Insurance Corporation (FDIC) protection up to $250,000 per individual. Corporate bonds, while not insured are backed by the financial viability of the underlying company. Should a company declare bankruptcy or liquidation, bondholders have a higher claim on company assets than do common shareholders.
Risks of Fixed Income Investments
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, Treasurys and CDs have protection through the government and FDIC. 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 investors 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 2-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.
Pros
- Steady income stream
- More stable returns than stocks
- Higher claim to the assets in bankruptcies
Cons
- Returns are lower than other investments
- Credit and default risk exposure
- Susceptible to interest rate risk
- Sensitive to Inflationary risk
