A fixed income is one that pays a fixed amount on a regular basis until maturity. Fixed-income investments are often less risky than equity investments. The returns are likewise frequently smaller and usually consist exclusively of fixed-income payments. Here, we’ll look at the meaning of fixed income, with a closer look at fixed-income assets and why investors should consider including them in their portfolios.
Meaning Of Fixed Income
Fixed income is a type of asset. Equities (e.g., stocks), cash and equivalents, real estate, commodities, and currencies are also common asset classes.
Fixed-income investments are debt investments that pay a predetermined interest rate on a regular basis. They allow investors to generate a consistent income until the investment matures. Income is the basic return on investment that an investor receives. An investor will receive their principal back at maturity.
Investing $10,000 in a 10-year bond with a 3.5% interest rate paid every six months until maturity is an example of a fixed-income investment. For the 10-year term, the investor would get a fixed income payment of $175 every six months ($350 yearly). The investor would receive their entire $10,000 principal upon maturity.
Types Of Fixed Income
There are numerous fixed-income investments with varying returns and risk profiles. They are as follows:
#1. Treasuries
The United States government issues a variety of fixed-income debt securities to help fund its activities. Treasury bills (T-bills), Treasury notes (T-notes), Treasury bonds (T-bonds), Treasury inflation-protected securities (TIPS), Series I savings bonds (I bonds), and other savings bonds are examples of these instruments. They range in length from four weeks to thirty years. Given the extraordinary improbability of a default, many investors regard US government debt as a risk-free investment.
#2. Municipal bonds (also known as Muni bonds)
State and local governments frequently issue fixed-income debt securities to support and assist local spending. Muni bonds likewise have a very low default risk.
#3. Corporate bonds
Corporations will also issue debt to fund their operations and growth. Corporate bonds are riskier than government bonds. The default risk, on the other hand, varies from minimal for an investment-grade rated corporate issuer to high for a corporation issuing junk bonds.
#4. Certificates of deposit (CDs) issued by banks
Many financial organizations provide CDs with fixed interest rates that last till maturity.
Individuals and institutions can also invest in loans or a package of loans provided directly to consumers and businesses through mortgages, loans, and associated instruments.
The Benefits of Fixed Income Investments
Fixed-income investments provide investors with a consistent source of income over the life of the bond or debt instrument while also providing the issuer with much-needed access to capital or money. Because consistent income allows investors to plan their expenditures, these products are popular in retirement portfolios.
#1. Relatively Less Volatile
Fixed-income interest payments can also assist investors in stabilizing the risk-return profile of their investment portfolio, often known as market risk. Stock values can fluctuate, resulting in big gains or losses for investors. Fixed-income products’ consistent and reliable interest payments might help to offset losses from equity price declines. As a result, these secure investments contribute to the diversification of an investment portfolio’s risk.
#2. Guarantees
Furthermore, the US government backs fixed-income investments in the form of Treasury bonds (T-bonds).
The financial stability of the underlying corporation serves as the security for corporate bonds, despite the lack of insurance. Bondholders have a greater claim on company assets than common shareholders if a corporation declares bankruptcy or liquidation. Additionally, the Securities Investor Protection Corporation (SIPC) covers bond assets held at brokerage firms for up to $500,000 in cash and securities. The Federal Deposit Insurance Corporation (FDIC) insures fixed-income CDs up to $250,000 per person.
Fixed rates are wonderful for reducing risk, but you can’t increase the rate once you’ve locked in. Fixed income assets are less appealing during inflationary periods because the rate you’ve locked in is likely to be lower than the current rate of return on fresh bond issuances.
Risks Associated With Fixed Income Investment
Although fixed-income products provide several advantages, as with any investments, investors should be aware of several risks before acquiring them.
#1. Default and Credit Risk
As previously stated, Treasuries and CDs are insured by the government and the FDIC.6 Corporate debt, while less secure, ranks higher in terms of repayment than shareholder debt. When selecting an investment, consider the credit rating of both the bond and the underlying firm. Bonds with ratings lower than BBB are considered trash bonds.
The credit risk associated with a firm can have various implications on the valuations of fixed-income instruments in the run-up to maturity. If a firm is struggling, the value of its bonds on the secondary market may fall. A failing corporation’s bonds may sell for less than their face value or par value if an investor tries to sell them. Furthermore, because there is no demand for the bond, it may become difficult for investors to sell it on the open market at a fair price or at all.
Bond prices can rise and fall over the course of the bond’s existence. If the investor holds the bond until maturity, the price variations are insignificant because the investor will be paid the face value of the bond. If a bondholder sells the bond before maturity through a broker or financial institution, the investor will receive the prevailing market price at the time of sale. Depending on the underlying firm, the coupon interest rate, and the current market interest rate, the selling price could result in a gain or loss on the investment.
#2. Risk of Interest Rates
Fixed-income investors may be exposed to interest rate risk. This risk occurs in a scenario where market interest rates are rising and the bond rate is falling behind. The bond would lose value in the secondary bond market in this circumstance. Furthermore, the investor’s capital is locked up in the investment, and they are unable to put it to work earning a greater income without incurring an initial loss.
For example, if an investor bought a two-year bond paying 2.5% per year and interest rates on two-year bonds rose to 5%, the investor is locked in at 2.5%. Investors in fixed-income products, for better or worse, receive their fixed rate regardless of where interest rates go in the market.
#3. Inflationary Risk
Inflationary risk also poses a threat to fixed-income investors. Inflation refers to the rate at which prices grow in the economy. If prices or inflation rise, the gains on fixed-income assets are reduced. For example, if fixed-rate debt security offers a 2% return while inflation rises by 1.5%, the investor loses money and earns just a 0.5% return in real terms.
Meaning Of Fixed Income Securities
A fixed-income security is an investment that pays fixed monthly interest payments and eventually returns principal at maturity. In contrast to variable-income securities, whose payments fluctuate based on an underlying measure such as short-term interest rates, the returns on a fixed-income security are predictable.
Fixed-Income Securities Credit Rating
Bonds are granted credit ratings based on the issuer’s financial sustainability. Credit ratings are a part of the grading system that credit-rating companies use. These agencies assess the creditworthiness of corporate and government bonds, as well as the ability of the business to repay these debts. Investors benefit from credit ratings because they define the risks associated with investing.
Bonds can be classified as investment-grade or non-investment-grade. Investment grade bonds are issued by solid corporations with low default risk and, as a result, have lower interest rates than non-investment grade bonds. Non-investment grade bonds, often known as junk bonds or high-yield bonds, have worse credit ratings due to the issuer’s likelihood of default. Investors that invest in junk bonds earn a higher interest rate in exchange for taking on the increased risk of these debt products.
Fixed-Income Security Types
#1. Treasury Notes
Treasury notes (T-notes) are intermediate-term bonds issued by the United States Treasury that maturity in two, three, five, or 10 years. T-Notes are typically $1,000 in face value and pay semiannual interest payments at fixed coupon rates or interest rates. All Treasurys’ interest and principal payments are guaranteed by the full faith and credit of the United States government, which issues these bonds to pay debts.
#2. Treasury Bonds
Treasury bonds (T-bonds) are also issued by the US Treasury and mature in 30 years. These bonds are normally issued with a par value of $10,000 and are auctioned off on the website TreasuryDirect.
#3. Treasury Bills
Treasury bills are examples of short-term fixed-income products. The T-bill matures one year after it is issued and does not pay interest. Instead, investors pay a lesser price than the security’s face value, or a discount. When the bill matures, investors are paid the face value. The difference between the purchase price and the face value of the bill is the interest earned or return on investment.
#4. Municipal Bonds
States, towns, and counties issue municipal bonds to fund capital projects like roads, schools, and hospitals. They are typically sold with a face value of $5,000. The interest on these bonds is not subject to federal income tax. If the investor resides in the state where the bond is issued, the interest received on a “muni” bond may be free from state and local taxes. The muni bond has multiple maturity dates, with a portion of the principal due at regular intervals until the entire amount is repaid.
#5. Certificate of Deposit
A bank is the one who issues certificates of deposit (CDs). The bank provides interest to the account holder in exchange for depositing money with the bank for a set period of time. CDs typically have maturities of less than five years and pay lower interest rates than bonds but higher interest rates than regular savings accounts. The Federal Deposit Insurance Corporation (FDIC) insures a CD up to $250,000 per account holder.
#6. Corporate Bonds
Corporate bonds are a type of debt security that businesses issue to raise money. Bond investors, unlike stockholders, have no voting rights or equity in the company. Bonds are categorized according to their maturity date. Short-term bonds are kept for three years or less, medium-term bonds for four to ten years, and long-term bonds for more than 10 years. Bonds are classed as investment- or non-investment-grade based on the credit rating of the issuing corporation.
#7. Preferred Stock
Companies offer preferred stock, which pays a fixed dividend in the form of a monetary amount or a percentage of share value on a predefined timetable. Because of their longer tenure, preferred shares have greater yields than most bonds due to interest rates and inflation.
Advantages And Disadvantages Of Fixed-Income Securities
Advantages
Fixed-income securities provide investors with consistent interest income, decrease risk in an investment portfolio, and safeguard against market volatility or swings. Because stocks are more volatile than bonds, investors may dedicate a part of their portfolios to fixed-income investments to decrease risk. Mutual funds and exchange-traded funds (ETFs) also provide fixed-income assets.
The value of bonds and fixed-income assets fluctuates. Although fixed-income securities pay consistent interest, their prices are not guaranteed to remain constant over the life of the investment. If an investor sells a fixed-income instrument before maturity, the gain or loss is calculated based on the difference between the buy and sale prices.
The United States Treasury guarantees government fixed-income securities, which are regarded as safe-haven investments. Corporate bonds are more vulnerable to default than government bonds because they are based on a company’s financial viability. Corporate bonds, on the other hand, are more likely to be repaid if a business declares bankruptcy since bondholders are paid before common investors.
Disadvantages
Fixed-income instruments are frequently associated with low returns and delayed capital appreciation or price increases. The initial principal amount is frequently unavailable, especially with long-term bonds with maturities of more than ten years.
Fixed-income securities pay a fixed interest rate independent of market interest rates. If market interest rates rise beyond 4%, an investor who acquired a 2%-per-year bond will lose money. If the inflation rate is higher than the interest rate on the fixed-income instrument, the return on the fixed-income instrument may be eroded.
Because the securities are linked to the issuer’s financial sustainability, all bonds entail credit or default risk. If the country is economically or politically unstable, investing in overseas bonds may increase the chance of default.
Why Is Fixed Income Called Fixed?
The borrower pledges to pay you a certain interest rate on a regular basis for a set period of time and until the bond’s maturity date in exchange for the usage of your money. Bonds are known as “fixed income” investments because of their consistent and predictable stream of interest.
What Type Of Income Is Fixed Income?
Fixed-income investing is a low-risk approach that seeks to generate consistent payments from investments such as bonds, money-market funds, and certificates of deposit, or CDs.
Can Fixed Income Lose Money?
Inflation reduces the purchasing power of fixed-interest payments on bonds. If inflation accelerates, the real return on bonds can fall, resulting in a loss for the investor.
In Conclusion
Fixed-income debt investments pay a fixed rate of interest as well as the repayment of the principal loaned upon maturity. These include various bonds and certificates of deposit. Fixed income is a less volatile asset type than equities (stocks) and is regarded as more conservative. A well-diversified portfolio should include a fixed-income allocation that grows in size as one’s time horizon shrinks (e.g., as retirement approaches).
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