What is fixed income? This is a question asked frequently? “Fixed income broadly refers to those types of investment security that pay investors fixed interest or dividend payments until its maturity date. At maturity, investors are repaid the principal amount they had invested”. The government and corporate bonds are the most common types of fixed-income products. They differ from equities in the way that it pays no cash flows to investors, or variable-income securities, where can payments change based on some underlying measure like short-term interest rates, and the payments of a fixed-income security are known in advance.
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.
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 are all examples of fixed-income products. Bonds traded over-the-counter or OTC on the bond market and secondary market. Fixed income investing is 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, lower as well. Building a fixed income portfolio may include investing in bonds, bond mutual funds, and certificates of deposit. This strategy of using fixed income products is called the laddering strategy.
The 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. 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.
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 collections. The interest payments from fixed-income products can also help investors stabilize the risk-return in their investment portfolio, which is also known as the market risk. For all those 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.
Although there are many benefits to fixed income products, as with all investments, there are several risks all investors should be aware of before purchasing them. Corporate debt, which is less secure still ranks higher for repayment than shareholders. While choosing an investment you need to take care to look at the credit rating of the bond and the underlying company. 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 market might decrease 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. It is also true, that the bond may become difficult for investors to sell in the open market at a fair price or not 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 till its maturity date, 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.
The investors of fixed-income might face the risk of interest rate. The risk happens in an environment where the interest rates in the market are rising, and the rate paid by the bond also 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 2-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 interest rates 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.