Fixed income is commonly referred to as those types of investment securities that pay an investor fixed interest (or dividend) until its maturity date. Upon maturity, investors are repaid the principal amount they had invested. Common fixed income investments include:
- Treasury bonds
- Government and agency bonds
- Municipal bonds
- Corporate bonds
- Mortgage-backed securities
Certificates of deposit and preferred stock can also be considered fixed income instruments.
What are some of the benefits of fixed income investing?
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. This conservative strategy offers investors returns generated from low-risk securities that pay reliable and consistent interest. Since the risk is lower, the interest payments tend to also be lower. Building a fixed income portfolio may include investing in bonds, certificates of deposit, and preferred stocks. We do not recommend bond mutual funds – and here’s why:
- Bond mutual funds typically have higher management fees than a comparable stock mutual fund.
- With an individual bond, risk decreases the longer you hold the security because as you get closer to maturity, the greater the likelihood you will receive your principal back from the company or organization to whom you lent it. This is not true with bond mutual funds because the individual holdings are constantly maturing, being bought and sold, and because bond mutual funds never mature.
- In the case of aggressive management, bond mutual funds can take on leverage. If you don’t pay attention to this, you might be exposed to potential capital losses and not even know it.
- Monthly income from bond mutual funds fluctuates as the underlying bond assets change.
- Some bond funds charge redemption fees if you sell your shares within a certain time period.
- Certain bond mutual funds may have fees and commissions to the fund company or financial institution that sold you the investment.
Unlike equities that may not pay frequent income to investors, or variable income securities, where payments change due to some underlying factor – the payments of the fixed income security, and the dates they are paid, are known up front.
What Are Some of The Risks Associated With Fixed Income Investing?
Research has shown that even a small fixed-income portfolio component, grounded in highly-rated bonds, can significantly reduce your portfolio’s overall volatility without subtracting too much from your portfolio return.
Although there are many benefits to fixed income products, as with other investments, there are several risks investors should be aware of before purchasing them. They are:
- Credit and Default Risk. Corporate bonds can make excellent investments. Before selecting an investment, be sure to look at the credit rating of the bond and the underlying company. Bonds with ratings below BBB are low quality and considered junk bonds.
- Interest Rate Risk. This risk happens in an environment where the market interest rates are rising while the rate paid by the bond lags. Subsequently, 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.
- Inflationary Risk. If prices rise or inflation increases, it eats into the gains of the fixed income security.
How Can I Invest In Fixed Income?
Instead of spending the time to research individual securities and run the risk of choosing the wrong bond, many advisors will just advise you to invest your money in a bond mutual fund to give you instant diversification. If the fund performs poorly, the advisor simply points blame on the bond fund manager.
With that said, it is strongly recommended that you seek guidance from an advisor that has the specialized training and knowledge to avoid mistakes and effectively create customized portfolios of actively managed individual fixed income securities.
The most common government securities are those issued by the U.S. government and are generally referred to as Treasury securities. However, many fixed income securities are offered by non-U.S. governments and corporations as well.
Below are the most common types of fixed income instruments:
- Treasury Bills are short-term fixed-income securities that mature within one year. Investors buy the bill at a price less than its face value and investors earn the difference at maturity.
- Treasury Notes range between two and 10 years. At the end of the maturity, investors are repaid the principal as well as semi-annual interest payments each year they hold the note.
- Treasury Bonds are like the T-note except that it matures in 30 years.
- Municipal Bonds are like Treasuries but are backed by a state, municipality, or county instead of the federal government. They can also have tax-free benefits to investors.
- Corporate Bonds come in various types. The price and interest rate offered depends on the company’s financial stability and creditworthiness.
Often, investors use a laddering strategy with fixed income instruments. This offers a steady interest income via short-term bonds. This method allows the investor to have access to ready capital and avoid losing out on rising market interest rates.
At the end of the day, investing for income can be a more conservative way to get a return on your investment.
On some level, I think most people understand they’re supposed to de-risk as they age. Does that mean switching to a 60-40 bond/stock portfolio where the majority, 60%, is in bonds and other income-producing investments, with the rest is still in stocks? Does it mean settling for low-yielding Treasury bonds that pay 2 or 3%? Most people who are at or near retirement, the types of people who need to be making these sorts of decisions, have no idea, and most growth-based advisors don’t either.
More importantly, investing for income requires a kind of experience that most advisors simply don’t have. It’s not as simple as investing in Treasury bonds or buying a CD. It’s a matter of wading into the pool of corporate bonds, preferred stock, and other income-generating investments that most advisors don’t specialize in.
When you buy a bond, you’re actually investing. Better yet, you’re investing by contract. There’s less risk involved. You know how much you make. You know how much you get back. It’s a contract. There’s no funny math, and there’s little guesswork about what will happen.
That’s why bonds are probably the single most boring investment on earth. However, at a certain age, you don’t want as much risk, you want steady income.