What is fixed income?
Fixed income is a type of investment guarantee that pays investors fixed interest payments until its due date. At maturity, investors are reimbursed for the capital they had invested. Government and corporate bonds are the most common types of fixed income products. However, there are exchange traded fixed income funds and mutual funds.
Bills and treasury bills, municipal bonds, corporate bonds and certificates of deposit (CD) are all examples of fixed income products. Bonds are traded over the counter (OTC) on the bond market and the secondary market.
Fixed income explained
Businesses and governments issue debt securities to raise funds to finance daily operations and finance large projects. Fixed income instruments pay investors a fixed interest rate in exchange for investors who lend their money. On the maturity date, investors are reimbursed for the initial amount they had invested, called capital.
For example, a business can issue a 5% bond with a nominal or nominal value of $ 1,000 that matures in five years. The investor purchases the bond for $ 1,000 and will not be redeemed until the end of the five years. Over 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 a year for five years. At the end of the five-year period – called maturity – the investor is reimbursed for the $ 1,000 initially invested. Investors can also find fixed income investments that redeem coupons monthly, quarterly or semi-annually.
Fixed income securities are recommended for prudent investors looking for a diversified portfolio. The percentage of the portfolio dedicated to fixed income securities depends on the investor’s style of investment. It is also possible to diversify the portfolio with a combination of fixed income and equity products, creating a portfolio that could have 50% in fixed income and 50% in equities.
Key points to remember
- Fixed income is a type of security that pays investors fixed interest payments until their maturity date.
- At maturity, investors are reimbursed for the capital they had invested.
- Government and corporate bonds are the most common types of fixed income products.
- In the event of the bankruptcy of a company, fixed income investors are paid before ordinary shareholders.
Types of Fixed Income Products
As noted earlier, the most common example of a fixed income security is a government or corporate bond.
- Treasury bills (Treasury bills) are short-term fixed income securities that mature within one year and do not redeem the coupon. Investors buy the invoice at a price lower than its nominal value and investors earn this difference at maturity.
- Treasury bills (T-notes) mature between two and 10 years, pay a fixed interest rate and generally have a face value of $ 1,000. At the end of the term, investors are reimbursed the principal but earn semi-annual interest payments 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. T-bills can have a face value of $ 10,000 each.
Inflation Protected Treasury Securities (TIPS) protect investors against inflation. The principal amount of a TIPS bond adjusts for inflation and deflation.
- A municipal bond is similar to Treasurys but is issued and supported by a state, municipality or county and finances capital expenditures. Muni bonds can also offer non-taxable benefits to investors.
- Corporate bonds are of different types and the price and interest rate offered depends largely on the financial stability of the business and its creditworthiness. Bonds with higher credit ratings generally pay lower coupon rates.
Unwanted bonds – also called high yield bonds – are issues of companies that pay a higher coupon due to the higher risk of default. The default is when a business fails to repay the principal and interest on a bond or debt instrument.
- A certificate of deposit (CD) is a fixed income vehicle offered by financial institutions with a maturity of less than five years. The rate is higher than a conventional savings account and CDs are protected by the FDIC or the National Credit Union Administration (NCUA).
- Fixed income mutual funds, such as those offered by Vanguard, invest in various bonds and debt securities. These funds allow the investor to have a stream of income with professional portfolio management. However, they will pay a fee for convenience.
- Asset allocation or fixed income ETFs work much like mutual funds. These funds target credit ratings, durations or other specific factors. ETFs also have professional management fees.
Fixed income investing as a strategy
Investing in fixed income securities is a prudent strategy where returns are generated from low risk securities that pay predictable interest. Since the risk is lower, the interest coupon payments are also, generally, also lower. 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 provides stable interest income through investment in a series of short-term bonds. As the bonds mature, the portfolio manager reinvests the returned capital in new short-term bonds that extend the scale. This method allows the investor to have access to loan capital and to avoid losing on rising market interest rates.
For example, an investment of $ 60,000 could be divided into one-year, two-year and three-year bonds. The investor divides the principle of $ 60,000 into three equal parts, investing $ 20,000 in each of the three bonds. When the one-year bond matures, the principal amount of $ 20,000 will be converted into a bond maturing one year after the initial three-year holding. When the second bond matures, these funds transform into a bond that extends the scale for another year. In this way, the investor has a regular return on interest income and can take advantage of higher interest rates.
Benefits of Fixed Income
Fixed income investments provide investors with a constant flow of income over the life of the bond or debt instrument while providing the issuer with essential access to capital or money. Regular income allows investors to plan their spending, which is why these products are popular in retirement portfolios.
Interest payments on fixed income products can also help investors stabilize the risk-return of their investment portfolio, called market risk. For investors holding stocks, prices can fluctuate, resulting in significant gains or losses. Stable and stable interest payments on fixed income products can partially offset losses from falling stock prices. Therefore, these safe investments help to diversify the risk of an investment portfolio.
In addition, fixed income investments in the form of treasury bonds (T bonds) are supported by the United States government. Fixed income CDs are protected by the Federal Deposit Insurance Corporation (FDIC) up to $ 250,000 per person. Corporate bonds, although uninsured, are supported by the financial viability of the underlying company. If a company declares bankruptcy or liquidation, bondholders have a higher claim on the assets of the company than ordinary shareholders.
Risks of Fixed Income Investments
Although fixed income products have many advantages, as with all investments, there are many risks investors should be aware of before buying them.
Credit and default risk
As mentioned earlier, Treasurys and CD are protected by the government and the FDIC. Corporate debt, although less secure, is still higher for repayment than shareholders. When choosing an investment, be sure to examine the credit rating of the bond and the underlying company. Bonds with a rating of less than BBB are of low quality and take into account unwanted bonds.
Credit risk linked to a company can have variable effects on the valuation of the fixed income instrument until its maturity. If a company experiences difficulties, the price of its bonds on the secondary market could fall in value. If an investor tries to sell a bond from a troubled business, the bond could sell for less than its nominal or nominal value. In addition, the obligation can become difficult for investors to sell on the open market at a fair price or not at all because there is no demand.
Bond prices can go up and down over the life of the bond. If the investor holds the bond until its maturity, the price movements are immaterial since the investor will receive the nominal value of the bond at maturity. However, if the bond holder sells the bond before its maturity through a broker or financial institution, the investor will receive the current market price at the time of sale. The sale price could result in a gain or a loss on the investment depending on the underlying company, the coupon interest rate and the current market interest rate.
Interest rate risk
Fixed income investors may be exposed to interest rate risk. This risk occurs in an environment where market interest rates rise and the rate paid by the bond falls. In this case, the bond would lose value on the secondary bond market. In addition, investors’ capital is tied up in the investment and they cannot use it to earn higher income without incurring an initial loss. For example, if an investor bought a 2-year bond paying 2.5% a year and interest rates on 2-year bonds increased to 5%, the investor is stuck at 2.5%. For better or worse, investors with fixed income products receive their fixed rate, no matter where interest rates move in the market.
Inflationary risk is also a danger for investors in fixed income securities. The rate at which prices rise in the economy is called inflation. If prices go up or inflation goes up, it eats away at fixed income gains. For example, if the fixed rate debt security yields 2% and inflation increases by 1.5%, the investor loses, earning only a return of 0.5% in real terms.
Stable revenue stream
More stable returns than stocks
Higher claim for assets in bankruptcy
The government and the FDIC support some
Returns are lower than other investments
Exposure to credit and default risk
Sensitive to interest rate risk
Sensitive to inflationary risk
Real example of fixed income investments
To illustrate this, suppose that Pepsico Inc. (PEP) is launching a fixed income bond issue for a new bottling plant in Argentina. The bond issued at 5% is available at a nominal value of $ 1,000 each and must mature in five years. The company plans to use the proceeds from the new plant to pay off debt.
You buy 10 bonds with a total cost of $ 10,000 and receive $ 500 in interest each year for five years (0.05 x $ 10,000 = $ 500). The amount of interest is fixed and gives you regular income. The company receives the $ 10,000 and uses the funds to build the plant abroad. At maturity in five years, the company will reimburse the capital of $ 10,000 to the investor who has earned a total of $ 2,500 in interest over the five years ($ 500 x five years).