This article is not about retirement. Although pensions and Social Security are a form of fixed income, this piece will discuss fixed income investments.
They are an important part of the market, and a key part of many long term portfolios. Here’s what fixed income investments are and how they work.
What Is Fixed Income?
Fixed income investments pay a regular rate of return on a fixed schedule. A loan upon which someone makes monthly payments with interest is an example of a fixed income investment for the creditor. Every month the borrower pays a set amount of interest and a minimum amount of principle, making payments regular in schedule and form.
The amount of a fixed income investment can vary depending on the nature of the asset. Typically, this happens when the investment is built around percentages of an uncertain quantity. An ETF which returns a percent of assets on a quarterly basis would be an example of a certain schedule, uncertain return fixed income investment. The investor knows when they will get paid and how the ETF will calculate that payment, but the specific amount will depend on fund performance.
How Fixed Income Works
Investors use fixed income for stability.
Most fixed income investments are built around debt. Loans, mortgages and bonds are all classic examples because the contractual nature of debt makes this an ideal structure for fixed income investments. In fact, few (if any) debt contracts are not fixed income, as debt-based investing generally requires a regular payment schedule in proscribed amounts.
Some form of equity investments, such as stocks, can provide fixed income investments. However the speculative nature of equity investments makes this more difficult. An investor doesn’t know how an equity will perform, and few promise specific returns on specific schedules because of this uncertainty.
Fixed income investments rarely have the potential rate of return of an equity or otherwise speculative investment. This is in large part because of their contractual nature. The parties agree to the rules of payment in advance, including rate of return. In some uncommon cases, such as an equity fund which structures regular payments, it is possible for a fixed income investment to produce unpredictably large returns. However, in most cases the debt structure of a fixed income investment means that payments have a pre-determined cap.
At the same time, as with all financial products, it is possible for the investment to collapse entirely. A debt investment always comes with the risk of default and nonpayment, even if that risk is small, such as in the case of U.S. Treasury Bonds. An investment based on underlying equities has all the same built-in risks of a stock investment, even if their degree of risk is modulated based on diversity.
This is arguably the main weakness of fixed income investments in your portfolio. They have an upper limit but no lower bound.
Types of Fixed Income
Any asset can qualify as a fixed income investment if it meets a few basic requirements:
- A payment or transfer on the investor’s part;
- A set payment schedule; and
- A set calculation or amount for rate of return.
Some of the most common forms of fixed income investment include:
1. Treasury Bonds, Bills and Notes
The U.S. Treasury issues three forms of debt. All three are fixed income securities which pay a return to investors based on the nature and duration of the note, at the end of which they repay the entire principal. Treasury Bonds and Notes accrue interest every six months. Treasury Notes, the shortest duration of the three investments, do not.
2. Municipal and State Bonds
This is the typical form of government debt for state and local governments. They pay a fixed interest rate over a term of years, after which they repay the entire principle. Like notes issued by the federal government, these are generally low interest due to the extremely low risk of default.
3. Corporate Bonds
Corporate bonds are structured over a period of years. These are similar to government bonds. They are long-term notes (typically on the order of 10 – 20 years) which accrue periodic interest and repay the entire principal at the end of the note. Junk bonds are a form of high-interest corporate bond for firms with poor credit.
4. Exchange Traded Funds (ETFs)
Some, but not all, ETFs qualify as a fixed income investment. These funds make scheduled payments to the investors. The rate and structure of these payments will depend on the underlying assets. Funds built around bonds and other forms of structured debt may pay a set rate of return, while those which make regular dividend payments on underlying equities may have a more speculative rate of return.
5. Certificates of Deposit (CDs)
Debt is issued by a bank to ensure a reliable pool of capital for other loans. The duration of a CD can range from months to years. The certificate of deposit accrues periodic interest and repays the entire principal at the end of the term. Rate of return and the rate at which interest accrues depends on the length of the certificate.
While it is rare for the retail investor to encounter a mortgage, this is also a form of fixed income investment. The duration of the mortgage is fixed by the note, typically lasting from 20 to 30 years. The mortgage accrues monthly interest, and the principal is paid in installments over the term of the loan.
7. Unsecured Debt
This is a loan not backed by a fixed asset, but which comes with a regular payment schedule and rate of interest. Credit card debt and student loans are two of the most common forms of unsecured debt, as neither comes backed with an underlying asset that the creditor can seize in case of default.
Fixed Income Benefits
The biggest reason an investor would add a fixed income security to their portfolio is that relative to another types of investments, fixed income can provide a sort of stability. If you are concerned about the risk or volatility of your other investments, having a fixed income security can help reduce risk while giving you a more diversified portfolio overall. The stability of a fixed income investment can also extend to income generation, since the rate of return is fixed on these investments.
Investors in fixed income securities from a company, like a bond, are also at a higher priority for assets than investors who hold common stock. That means that in a scenario where the company has to declare bankruptcy, a bondholder is more likely to actually get their investment back.
Fixed Income Risks
However, there are still plenty of risks to these investments that you should be wary of.
If you are holding onto bonds for your fixed income investment, you can run into interest rate risk. That’s because a rise in interest rates tends to correlate with a decrease in bond value, making them harder to sell and thus more difficult for you to profit from them.
Similarly, inflation risk is a danger for fixed income investments. Because everything is fixed, the economic inflation tends to harm the value.
Certain fixed income investments can also involve credit risk if you aren’t careful. Investment-grade corporate bonds can be risky because of the possibility that the debtor can default on their obligations, leaving bondholders unable to recoup their full investment.
Should You Use Fixed Income?
Fixed income investing is an important part of any well-balanced portfolio. The low-risk, predictable nature of this investment can add essential stability relative to the uncertain nature of stocks and commodities.
Three investor profiles in particular, however, should consider fixed income investing as a significant part of their portfolio.
Retired Investors or Investors With a Set and/or Limited Income
This investor profile has a lower capacity for risk. The set or limited nature of their income means that they can less easily recover losses if a more speculative asset declines in value.
In particular, retirees should consider fixed income investments as an important part of their portfolio. The predictable nature of returns complement the financial planning of retirement, which is often built around knowing and predicting your income for decades to come. While the long-term nature of many fixed income investments may not suit every retiree’s portfolio, their security is essential for an investor for whom going back to work is not an option.
Investors in an Unstable, Uncertain or Otherwise Declining Market
Market volatility does not necessarily mean that you should turn all of your money into cash. As Warren Buffet advises, a downturn is often exactly when you should be putting more money into the stock market.
However, chaos also calls for portfolio stability. If you believe that the market has become too uncertain, fixed income investments are a good option. They allow you to take your money out of increasingly uncertain assets, while at the same time keeping a rate of return greater than that of a savings account.
Investors With Specific, Long-Term Plans
One of the other major downsides to a fixed income investment is the duration. Most of these investments keep your money locked up for years, if not decades. This makes them difficult for a retail investor to plan around in large quantities.
For an investor with specific, articulated and long-term investment goals, this may not be a problem. The classic example of this is a parent who begins their child’s college savings account. A bond which matures in 10 or 20 years works for this profile, as they know they won’t need this money for decades to come.
Although it is important to have stability against rate of return, 20 years is a long time to keep your money tied up in a low-yield investment. Even long-term savers should make sure to balance their portfolio between security and gains.
This article was originally published by TheStreet.