What Is Fixed Income?
Fixed income broadly refers to those types of investment security that pay investors fixed interest or dividend payments until their maturity date. At maturity, investors are repaid the principal amount they had invested. Government and corporate bonds are the most common types of fixed-income products.
Unlike equities that may pay out no cash flows to investors, or variable-income securities, where payments can change based on some underlying measure—such as short-term interest rates—the payments of a fixed-income security are known in advance and remain fixed throughout.
In addition to purchasing fixed-income securities directly, there are several fixed-income exchange-traded funds (ETFs) and mutual funds available to investors.
- Fixed income is a class of assets and securities that pay out a set level of cash flows to investors, typically in the form of fixed interest or dividends.
- Government and corporate bonds are the most common types of fixed-income products.
- They are known as fixed-income because they pay a fixed interest rate credited to investors.
- At maturity for many fixed income securities, investors are repaid the principal amount they had invested in addition to the interest they have received.
- In the event of a company's bankruptcy, fixed-income investors are often paid before common stockholders.
Understanding Fixed Income
Companies and governments issue debt securities to raise money to fund day-to-day operations and finance large projects. For investors, fixed-income instruments pay a set interest rate return in exchange for investors lending their money. At the maturity date, investors are repaid the original amount they had invested—known as the principal.
For example, a company might issue a 5% bond with a $1,000 face or par value that matures in five years. The investor buys the bond for $1,000 and will not be paid back until the end of the five years. Over the course of 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 per year for five years. At the end of the five years, the investor is repaid the $1,000 invested initially on the maturity date. Investors may also find fixed-income investments that pay coupon payments monthly, quarterly, or semiannually.
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. There is also an opportunity to diversify the portfolio with a mix of fixed-income products and stocks creating a portfolio that might have 50% in fixed-income products and 50% in stocks.
Treasury bonds and bills, municipal bonds, corporate bonds, and certificates of deposit (CDs) are all examples of fixed-income products. Bonds trade over-the-counter (OTC) on the bond market and secondary market.
Types of Fixed Income Products
As stated earlier, the most common example of a fixed-income security is a government or corporate bond. The most common government securities are those issued by the U.S. government and are generally referred to as Treasury securities. Fixed-income securities are offered by non-U.S. governments and corporations as well.
Here are the most common types of fixed income products:
- Treasury bills (T-bills) are short-term fixed-income securities that mature within one year that do not pay coupon returns. Investors buy the bill at a price less than its face value and investors earn that difference at maturity.
- Treasury notes (T-notes) come in maturities between two and 10 years, pay a fixed interest rate, and are sold in multiples of $100. At the end of maturity, investors are repaid the principal but earn semiannual interest payments until maturity.
- Treasury bonds (T-bonds) are similar to the T-note except that it matures in 20 or 30 years. Treasury bonds can be purchased in multiples of $100.
- Treasury Inflation-Protected Securities (TIPS) protect investors from inflation. The principal amount of a TIPS bond adjusts with inflation and deflation.
- A municipal bond is similar to a Treasury since it is government-issued, except it is issued and backed by a state, municipality, or county, instead of the federal government, and is used to raise capital to finance local expenditures. Muni bonds can have tax-free benefits to investors as well.
- Corporate bonds come in various types, and the price and interest rate offered largely depend on the company’s financial stability and its creditworthiness. Bonds with higher credit ratings typically pay lower coupon rates.
- Junk bonds—also called high-yield bonds—are corporate issues that pay a greater coupon due to the higher risk of default. Default is when a company fails to pay back the principal and interest on a bond or debt security.
- A certificate of deposit (CD) is a fixed income vehicle offered by financial institutions with maturities of less than five years. The rate is higher than a typical saving account, and CDs carry FDIC or National Credit Union Administration (NCUA) protection.
Traditional portfolio theory claims that an efficient investment strategy attempting to balance risk and returns should diversify in stocks and bonds. Stocks tend to be riskier with higher potential returns, while fixed income securities are safer with usually lower returns.
How to Invest in Fixed Income
Investors looking to add fixed-income securities to their portfolios have several options. Today, most brokers offer customers direct access to a range of bond markets from Treasuries to corporate bonds to munis. For those who do not want to select individual bonds, Fixed-income mutual funds (bond funds) give exposure to various bonds and debt instruments. These funds allow the investor to have an income stream with the professional management of the portfolio. Fixed income ETFs work much like a mutual fund, but may be more accessible and more cost-effective to individual investors. These ETFs may target specific credit ratings, durations, or other factors. ETFs also carry a professional management expense.
Fixed-income investing is generally a conservative strategy where returns are generated from low-risk securities that pay predictable interest. Since the risk is lower, the interest coupon payments are also, usually, lower as well. 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 offers steady interest income through the investment in a series of short-term bonds. As bonds mature, the portfolio manager reinvests the returned principal into new short-term bonds extending the ladder. This method allows the investor to have access to ready capital and avoid losing out on rising market interest rates.
For example, a $60,000 investment could be divided into one-year, two-year, and three-year bonds. The investor divides the $60,000 principle into three equal portions, investing $20,000 into each of the three bonds. When the one-year bond matures, the $20,000 principal will be rolled into a bond maturing one year after the original three-year holding. When the second bond matures those funds roll into a bond that extends the ladder for another year. In this way, the investor has a steady return of interest income and can take advantage of any higher interest rates.
Advantages of Fixed Income
Fixed-income investments offer investors a steady stream of income over the life of the bond or debt instrument while simultaneously offering the issuer much-needed access to capital or money. Steady income lets investors plan for spending, a reason these are popular products in retirement portfolios.
Relatively Less Volatile
The interest payments from fixed-income products can also help investors stabilize the risk-return in their investment portfolio—known as the market risk. For investors holding stocks, prices can fluctuate resulting in large gains or losses. The steady and stable interest payments from fixed-income products can partly offset losses from the decline in stock prices. As a result, these safe investments help to diversify the risk of an investment portfolio.
Also, fixed-income investments in the form of Treasury bonds (T-bonds) have the backing of the U.S. government.
Corporate bonds, while not insured are backed by the financial viability of the underlying company. Should a company declare bankruptcy or liquidation, bondholders have a higher claim on company assets than do common shareholders. Moreover, bond investments held at brokerage firms are backed by the Securities Investor Protection Corporation (SIPC) up to $500,000 coverage for cash and securities held by the firm. Fixed income CDs have Federal Deposit Insurance Corporation (FDIC) protection up to $250,000 per individual.
Fixed rates are great to reduce risk, but once you're locked in, you can't increase the rate. During inflationary periods, fixed income securities are less favorable as the rate you've locked into in the past is likely less than the current rate of return for new bond issuances.
Risks Associated With Fixed Income
Although there are many benefits to fixed income products, as with all investments, there are several risks investors should be aware of before purchasing them.
Credit and Default Risk
As mentioned earlier, Treasuries and CDs have protection through the government and FDIC. Corporate debt, while less secure still ranks higher for repayment than do shareholders. When choosing an investment take care to look at the credit rating of the bond and the underlying company. Bonds with ratings below BBB are of low quality and consider junk bonds.
The credit risk linked to a corporation can have varying effects on the valuations of the fixed-income instrument leading up to its maturity. If a company is struggling, the prices of its bonds on the secondary market might decline in value. If an investor tries to sell a bond of a struggling company, the bond might sell for less than the face or par value. Also, the bond may become difficult for investors to sell in the open market at a fair price or at all because there's no demand for it.
The prices of bonds can increase and decrease over the life of the bond. If the investor holds the bond until its maturity, the price movements are immaterial since the investor will be paid the face value of the bond upon maturity. However, if the bondholder sells the bond before its maturity through a broker or financial institution, the investor will receive the current market price at the time of the sale. The selling price could result in a gain or loss on the investment depending on the underlying corporation, the coupon interest rate, and the current market interest rate.
Interest Rate Risk
Fixed-income investors might face interest rate risk. This risk happens in an environment where market interest rates are rising, and the rate paid by the bond falls behind. In this case, the bond would lose value in the secondary bond market. Also, 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.
For example, if an investor purchased a two-year bond paying 2.5% per year and interest rates for 2-year bonds jumped to 5%, the investor is locked in at 2.5%.?For better or worse, investors holding fixed-income products receive their fixed rate regardless of where interest rates move in the market.
Inflationary risk is also a danger to fixed-income investors. The pace at which prices rise in the economy is called inflation. If prices rise or inflation increases, it eats into the gains of fixed-income securities. For example, if fixed-rate debt security pays a 2% return and inflation rises by 1.5%, the investor loses out, earning only a 0.5% return in real terms.
Fixed Income Pros and Cons
Steady income stream of fixed returns
More stable returns than stocks
Higher claim to the assets in bankruptcies
Government and FDIC backing on some
Returns are often lower than other investments
Credit and default risk exposure
Susceptible to interest rate risk
Sensitive to Inflationary risk
Some government bonds like Treasury Inflation-Protected Securities (TIPS) are indexed to changes in the inflation rate and protect investors accordingly.
Fixed Income Analysis: What to Consider
When deciding which of these financial products to invest in, investors perform fixed income analysis. The techniques below are used to evaluate which investments make best sense for the investor's risk appetite and expected returns.
Fixed income analysis often begins with risk. All investments have a relationship between its risk and its return; all else equal, an investment's returns should be higher when the investment is riskier. Therefore, fixed income analysis not only assesses whether an investor is comfortable with the level of risk they are taking on but whether the level of risk is appropriate for a fixed income security's return.
For fixed income securities, risk is tied to the creditworthiness of the issuing company, length of the fixed income security, and industry in which the company participates in. For example, you'll often find the lowest return fixed income securities related to the U.S. government. Because risk of default is low, U.S. bonds are often seen as safer forms of investments. On the other hand, corporations (especially ones with cashflow problems) may post greater risk.
Some fixed income securities offer periodic payments. This allows investors to recoup funds during the duration of the investment. This also reduces risk, as not all capital needs to be returned at the end of a potentially long bond term.
Last, different fixed income securities have different features that make them more or less appealing. Some may be callable where the debtor can repay the full bond prior to maturity. Other allows for the fixed income security to be converted to common stock. It's critical to consider what features are important to you, as each favorable term likely reduces yield.
Example of Fixed Income
To illustrate, let's say PepsiCo (PEP) issues fixed-rate bonds for a new bottling plant in Argentina. The issued 5% bond is available at face value of $1,000 each and is due to mature in five years. The company plans to use proceeds from the new plant to repay the debt.
You purchase 10 bonds costing a total of $10,000 and will receive $500 in interest payments each year for five years (0.05 x $10,000 = $500). The interest amount is fixed and gives you a steady income. The company receives the $10,000 and uses the funds to build the overseas plant. Upon maturity in five years, the company pays back the principal amount of $10,000 to the investor who earned a total of $2,500 in interest over the five years ($500 x five years).
What Are Examples of Fixed-Income Securities?
Fixed-income securities are debt instruments that pay a fixed rate of interest. These can include bonds issued by governments or corporations, CDs, money market funds, and commercial paper. Preferred stock is sometimes considered fixed-income as well since it is a hybrid security combining features of debt and equity.
What Is the Difference Between Fixed-Income and Equity Securities?
Fixed-income securities are debt instruments that pay interest to investors along with the return of the principal amount when the bond matures. Equity, on the other hand, is issued in the form of company stock and represents a residual ownership stake in the firm, and not a debt. Equity does not have a maturation date, and while it may pay a dividend makes no guaranteed payments to investors. In general, equity is a higher-risk/higher-return security than a company's bonds.
How Does Inflation Affect Fixed Income?
Inflation will often have a negative effect on the value of fixed-income securities when it leads to higher interest rates. This is because the prices of bonds and other fixed-income securities are negatively correlated with interest rate changes.
What Is a Fixed Rate vs. Variable Rate Bond?
Fixed-rate bonds pay the same interest rate over their entire maturity. These can be contrasted with floating or?variable rate?bonds, which periodically reset the interest rate paid based on prevailing rates in the market.
The Bottom Line
Fixed income refers to debt investments that pay a fixed rate of interest, along with the return of the principal loaned upon maturity. These include different types of bonds and certificates of deposit. Fixed income as an asset class is generally less volatile than equity (stocks), and is considered to be more conservative. A well-diversified portfolio should have some allocation to fixed income that becomes increasingly larger as one's time horizon shortens (e.g. as retirement approaches).