Fixed income investments include the wide universe of bond securities
Fixed income investing is an investment strategy that prioritizes reliable cash payments on a fixed schedule with less consideration to long-term price appreciation. Fixed income investments include the wide universe of bond securities, as well as a few other types of securities such as CDs and money market funds.
We’ll discuss what fixed income investing means, why these types of investments exist, and for whom they’re most appropriate. We’ll also explain some of the pros and cons of each type of fixed income investment.
What is fixed income investing?
When we refer to fixed income, we’re talking about securities that generate some amount of income on a predictable schedule. In most market environments, the price of these securities tends to be less volatile than stocks, which makes them an attractive portfolio diversifier.
Fixed income securities usually focus more on capital preservation — that is, not losing money — than long-term price appreciation, which is a common goal for younger investors. The idea with fixed income is to maintain and protect your balances over time, all while earning income on a reliable schedule.
Fixed income can be appropriate for investors of all ages, although it tends to play a more active role in portfolios as investors age and approach retirement. Fixed income can serve as a valuable source of retirement income. It can also be a stabilizing vehicle, which is especially valuable since a retiree’s risk tolerance is usually lower compared to when they were working.
Pros and cons of fixed income investing
Let’s go over the many pros and cons of fixed income investments.
Pros
- They receive a fairly predictable income stream and modest capital preservation.
- Fixed income investments have historically acted as reliable portfolio diversifiers to stocks. Put another way, since stocks tend to move up and down fairly quickly, fixed income securities typically act as a portfolio stabilizer.
- Provide additional security for those approaching retirement or in retirement. People approaching retirement may not want to take as much stock market risk as they did when they were just starting out.
- Overall, they’re less volatile than stocks, although there have been moments when this has not been the case.
Cons
- Certain fixed income investments can be very sensitive to changes in interest rates, which can limit their price stability. As we’ve seen in the first and second quarter of 2022, rising interest rates have meaningfully hurt bond prices.
- Fixed income investments are also hurt by inflation, especially roaring inflation like we’ve seen in 2022. Many of the more stable fixed income options, such as Treasury bills, have delivered negative real returns to investors. In other words, because nominal interest rates have been so low (between 1% to 3%, depending on the security), real interest rates have been negative after accounting for inflation.
- Because of low real yields, some argue that fixed income isn’t necessary if you have a high amount of fixed interest rate debt outstanding. For example, if you have a 12% credit card loan outstanding, you’d likely be better off knocking out the debt before adding fixed income investments to your portfolio.
- There is limited upside, particularly during times of rising interest rates and high inflation environments.
Types of fixed income investments
Treasury bonds
Treasury bonds are issued by the federal government and pay a fixed rate of interest that compounds semi-annually. The current interest rate for newly issued 30-year Treasury bonds is 2.875%. Treasury bonds might be appealing to investors who seek a reliable stream of income with essentially no risk of default by the issuer (the U.S. government). Still, investors should be aware that Treasury bond prices, especially the long-dated ones (20- and 30-year bonds), come with interest rate risk.
Source: https://www.treasurydirect.gov/instit/annceresult/annceresult.htm
Savings bonds
Savings bonds are similar to Treasury bonds in that they are backed by the U.S. government, but they have a few distinct characteristics. They’re usually meant for long-term, conservative savers who value periodic income and safety of principal. The upside is that the underlying value of the bond won’t change even when interest rates move, and, when the bond reaches maturity, it can be redeemed for face value plus any accrued interest.
Municipal bonds
Municipal bonds are fixed-income securities issued by state and local governments. Municipal bonds, or “muni bonds,” are federally tax-free and may be nontaxable on the state and local levels if the investor lives in the state where the muni bond was issued. Because of their inherent tax advantages, muni bonds are especially appealing to investors who find themselves in a high tax bracket.
Muni bonds are at greater risk of default than Treasury bonds since some bond issuances on the state and local levels can be related to projects that may not achieve their expected revenue goals. Further, much the same as most fixed income securities, rising interest rates will negatively impact muni bonds and their current prices.
Corporate bonds
Corporate bonds are issued by corporations seeking to raise money through debt. The debt proceeds are usually used in some form to support the company’s ongoing operations. Corporate bonds will have varying degrees of default risk, depending on the issuing company’s financial solvency, and they will also carry interest rate risk, depending on the term of the bond. (As noted earlier, longer-dated corporate bonds will have greater interest rate risk.)
Bonds issued by major publicly traded companies are corporate bonds. Each will deliver a fixed coupon rate (unless it’s a zero-coupon bond) and offer different interest rate characteristics.
Junk bonds
Junk bonds are considered risky fixed income investments. Bonds receive a “junk” rating if their issuer is having significant financial problems and/or stands a reasonable chance of becoming insolvent. Junk bonds tend to pay a higher interest rate to their holders to compensate for the inherent risk of investing, but this comes at a price: The chance of default is far higher than that of investment-grade securities. In other words, when you invest in junk bonds, there’s a decent chance you won’t get your money back at all. And, if you do get your money back, it may only be a fraction of what you invested.
CDs
CDs, or certificates of deposit, are long-term financial instruments that you can buy at most financial institutions. CDs offer fixed, guaranteed interest rates for the promise to keep your money at the institution of your choice for a minimum period of time. The rate of interest paid on CDs is typically not very high, but it’s better than most checking and savings accounts — usually in the 1% to 2% range.
A CD might work for a cautious investor who wants financial security for a specified period of time and can typically make sense as part of a broader financial plan. On the plus side, you’ll be guaranteed to get your money back plus interest. However, interest rates aren’t very high relative to current inflation.
Bond mutual funds
Bond mutual funds operate much like stock mutual funds, but the underlying fund holdings are fixed income securities rather than common or preferred stocks. Instead of directly receiving interest payments from the bonds themselves, you receive one monthly or quarterly dividend paid from the mutual fund itself.
Bond mutual funds offer high levels of diversification relative to owning individual bonds, which makes them appealing to long-term investors of all backgrounds. You can buy bond mutual funds that cover a particular locale, sector, tax strategy, or even the entire bond universe. These tend to make sense for minimalist investors who like to keep their portfolio simple.
Bond ETFs
Bond ETFs, or exchange-traded funds, trade throughout the day on an exchange and can be bought and sold freely like most stocks. Bond ETFs are composed of many bonds taken together. Similar to bond mutual funds, they can cover a variety of sectors or tax strategies. Also similar to bond mutual funds, the bond ETF holder can expect either a monthly or quarterly dividend from the fund itself.
Because bond ETFs expose the investor to hundreds of underlying fixed income securities, they tend to work well as a portfolio diversifier. The choice between bond mutual funds vs. ETFs is often a matter of personal preference.
Is fixed income right for your portfolio?
One of the core tenets of successful long-term investing is to ensure that your portfolio is properly diversified. Historically, fixed income securities have acted as great diversifiers to stocks, often moving in the opposite direction and providing portfolio balance. While this hasn’t been the case in the first half of 2022, we can expect fixed income to still offer some level of diversification going forward.
The main risks associated with fixed income investing are interest rate risk, default risk, and inflation risk. In times of rising interest rates, fixed income securities will show principal losses, although security holders will still benefit from a reliable income stream. Default risk is most present when the bond issuer is a financially unstable company, while it tends to be minimal when it’s the U.S. government. Inflation risk erodes the real purchasing power of your money, and, in 2022, it’s certainly top of mind.
Despite the risks, there can certainly be room for fixed income investments in your portfolio. It’s generally best to look at your portfolio from a bird’s-eye view and allocate a certain amount to stocks, a certain amount to bonds, and a certain amount to other asset classes.
As has been said at The Motley Fool and elsewhere: A diversified portfolio is likely to reduce volatility and give you a smoother ride to a successful financial future.
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