Why and When to Choose Fixed Income Investments
What are fixed-income investments, and when might they be a good idea? Here we fill you in on the basics of this investment approach.
Fixed-income investments are favored by many investors and retirees because they provide a regular income stream. You invest in a class of securities and assets that pay dividends or fixed interest in the form of coupon payments.
Depending on the investment, you may receive coupon payments monthly, quarterly, semi-annually or once a year. When many of these investments mature, you get the principal back.
What are you investing in with fixed income?
Governments and companies issue debt securities as a way to finance initiatives or projects. Investors can then purchase these securities, which essentially amount to a loan of the principal to that government or corporate entity. Until the maturity date, you receive set interest payments as income.
The most common types of fixed income products are corporate and government (Treasury or municipal) bonds. Other options include Treasury bills (T-bills), notes (T-notes), and Treasury Inflation-Protected Securities (TIPS).
You can purchase fixed-income securities directly, or you can invest in fixed-income mutual funds and exchange-traded funds (ETFs).
What are the benefits of including fixed income in an investment strategy?
These investments are more conservative in nature and can help you diversify your portfolio, provide dependable income, and protect and preserve principal. They can even help you minimize taxes because some fixed-income securities receive preferential tax treatment.
Who should select fixed income securities?
These types of investments are often recommended for conservative investors as part of a diversified portfolio. This is because the risk is lower relative to some other types of investments, such as stocks.
What are the risks?
Although the risk is relatively lower with this type of investment, there’s no such thing as a zero-risk investment. Here are some of the main risks associated with fixed-income securities:
First, interest rate risk. The primary cause of volatility in the bond markets has to do with interest rates. Bond prices decline — losing value — when interest rates increase.
Second, credit risk. If the issuer of the bond defaults on its debt obligations, there’s a possibility that you won’t receive the full value of your principal. (However, it’s good to know that if a company does go bankrupt, fixed-income investors are often paid first.)
Third, inflationary risk. Purchasing power is always compromised with inflation, and that’s the case here, too. If the rate of inflation is greater than the amount of fixed income, that income won’t go as far.
Fourth, liquidity risk. If you want to sell a fixed income asset, such as an individual bond you purchased from a corporation, but aren’t able to find a buyer, you’re locked into that investment.
Despite these risks, fixed-income investments are generally considered safe. For example, T-bonds are backed by the U.S. government, and fixed income certificates of deposit (CDs) have FDIC protection up to $250,000 per individual.
Lower risk does often equate to lower returns, but for investors seeking some predictability in their income from investments and who need to be in a more conservative investing position, that tradeoff can make sense.