Definition:
A fixed income investment (also known as an asset bought to be held as an investment) pays investors a constant interest rate until it matures. The original investment principal is repaid when it matures.
What it is?
Fixed income investments are intended to provide investors with a consistent income. This is accomplished through regular fixed interest payments. Fixed income securities appeal to investors seeking low-risk investments with consistent income streams. When these securities mature, the issuers (also known as borrowers) are required to repay the investor the principal amount invested. This is yet another reason why risk-averse investors may prefer fixed income securities to stocks. Government and corporate bonds are the most frequent type of fixed income investment securities.
Types of fixed income investment securities
Fixed income securities are divided into two types: short-term and long-term securities. Here’s a quick rundown of them.
Short-term fixed-income securities:
- Treasury bills are federal government-issued short-term fixed-income securities. They mature in a year and do not pay interest on a regular basis. Typically, investors purchase Treasury bills at a lower price than the face value (‘discount’) and profit when the bill matures.
- A Treasury note, also known as a T-note, has a maturity period of two to ten years. Investors receive semi-annual coupon payments as well as the principal amount invested at maturity.
- A certificate of deposit (CD) is a fixed-income security issued by banks. CDs typically mature in less than five years and pay a higher interest rate than a standard savings account.
Medium-term and Long-term fixed income securities:
- Treasury bonds are also fixed income securities issued by the federal government with maturities ranging from one to thirty years.
- Investors concerned about inflation should consider Treasury Inflation-Protected Securities (TIPS). TIPs are long-term fixed-income securities whose principal adjusts in response to inflation and deflation.
- Municipal bonds are debt instruments issued by states and local governments. Municipal bond interest is generally exempt from federal taxation in the United States. If the investor lives in the state where the bond is issued, he or she is usually exempt from state income taxes on the interest as well.
- Companies, both public and private, issue corporate bonds. They are usually more risky than government-issued debt securities. Because governments, as issuers of these securities, have higher levels of creditworthiness than individual companies.
- Junk bonds are corporate bonds with low credit ratings. Companies pay a higher coupon than standard corporate bonds due to the increased risk of not being able to pay the principal or all of the interest to investors. Companies typically issue these to fund acquisitions, special projects, and ongoing business operations.
- The assets of a fixed-income mutual fund are invested in a portfolio of bonds and debt instruments. This will be done on behalf of the fund’s investors by a professional management company. For these services, the investor is charged a management fee.
- Fixed-income ETFs function similarly to mutual funds. A professional management team handles these and charges the investor a management fee for investments that target specific credit ratings and durations.
Fixed income has both advantages and disadvantages. The benefits include consistent income and portfolio diversification. Meanwhile, inflationary risk is one of the most significant risks that investors take when investing in fixed income securities.
Fixed Income Derivatives
Derivatives are used by some investors to manage risk. Derivatives are bets on the future direction of a security. The derivative holder does not own the underlying asset. Please keep in mind that the following approaches are extremely risky and are not suitable for the average investor. They are also extremely complex, necessitating extensive education before investing.
- The owner of an option has the opportunity to buy or sell a certain security at a specific price at a future date, but not the duty to do so.
- Futures contracts obligate both the buyer and the seller to complete the transaction on the contract’s maturity date. Unlike listed options, which are traded on an exchange, forward contracts are exchanged over-the-counter (in a decentralized market). They are similar to futures contracts but are tailored to the requirements of the parties. A price is agreed upon between the buyer and the seller for the sale to take place at a later date.
What should you think about bonds?
Bonds are the most popular fixed income investment. We’ve established that bonds work as an IOU (binding legal document outlining a specific debt obligation), where an investor (aka lender) loans money to an issuer (aka borrower) for a predetermined period in exchange for interest payments throughout the investment’s term and the principal at maturity. What aspects should a bond investor take into account?
Whether to invest in individual bonds or bond funds is up to the investor. By aligning the maturity date of a bond to the client’s particular income requirements, individual bonds enable the investor to manage cash flow.
Bond fund types
1. The goal of bond index funds is to replicate the performance of a certain index or market benchmark at a reasonable cost (management costs are lower than those of actively managed bond funds).
2. A more liquid option to invest in bond indices is through bond ETFs. An exchange-traded fund that invests in bonds is known as a bond ETF.
3. Another choice is to put money into actively managed bond funds, where an investment manager selects bonds that they think will perform better than the benchmark for the fund. Investors may receive possibly larger returns from this alternative than from bond index funds, but at a higher cost.
Keep in mind: when interest rates are rising, fixed income instruments are more susceptible to principal loss. Other risks associated with fixed income investments include alterations in credit quality, market values, liquidity, etc.