What Is Fixed Income?
The term “fixed income investment” is often used interchangeably with bonds, which are essentially loans made to a private company or government, but can also represent other investments like CDs and preferred shares.
Like most loans, fixed income investments will earn the lender a rate of interest, most often a fixed rate. Fixed-income investments are known for offering better preservation of capital than stocks, but are not without risk of loss, especially corporate bonds.
Typically, fixed income investments include:
- Government bonds
- Corporate bonds
- Certificates of deposit (CDs)
- Preferred shares
How Fixed Income Investments Work
With fixed income investments, investors usually know exactly how much return they will receive monthly, quarterly, semiannually, or annually. Most fixed-income investments have a known maturity date when the principal investment amount will be returned.
Most fixed-income investments have the following attributes:
- Face value (or maturity value): also known as "par value" or "par," face value is the amount that will be paid to the investor once the investment matures. Bonds are typically issued in $1,000 increments.
- Coupon rate (or interest rate): the yield paid on the bond's face value.
- Term (or maturity date): the length of time until the fixed-income investment matures.
For example, an investor who purchases a $10,000 bond having a coupon rate of 5% and a maturity date of five years will receive interest of $500 each year plus the return of their initial investment ($10,000) at the end of year five. The total return in this example would be:
$500 interest* 5 years= $2,500
$2,500 / $10,000 = 25%.
Fixed Income Options
The primary types of fixed income investments are:
Treasuries (including TIPS)
Corporate Bonds
Municipal Bonds
Certificates of Deposit (CDs)
Preferred Shares
Fixed Income Mutual Funds and ETFs
1. Treasuries
There are three main types of Treasuries:
- Treasury bills (T-bills): mature in less than one year and do not pay coupon returns, rather their interest is recouped at maturity.
- Treasury notes (T-notes): mature in 2, 3, 5, or 10 years, pay semiannual interest and are sold in multiples of $100.
- Treasury bonds (T-bonds): have maturity dates between 10 and 30 years, pay semi-annual interest, and come in multiples of $100.
TIPS, or Treasury inflation protected securities, have interest rates that are adjusted semiannually to be in line with inflation rates, and their par value increases with inflation or decreases with deflation according to the Consumer Price Index. They have maturity dates of 5, 10, or 30 years.
2. Corporate Bonds
Corporate Bonds operate similarly to government bonds/Treasuries but are issued by a corporation. Corporations carry higher risk than the U.S. government, so these bonds will offer higher yields.
Note: Bonds issued by foreign governments, especially those that are less creditworthy, may pay higher interest rates than some corporate bonds.
3. Municipal Bonds
Also known as "munis," municipal bonds are debt securities that are issued by states, cities, counties, and other governmental entities to finance projects such as the building of highways or schools. Munis can have maturity dates ranging from between one year and 10 years.
The interest on municipal bonds is typically exempt from federal income tax and may be exempt from state and local taxes if the bond's purchaser resides within the state where the bond was issued.
4. CDs
Certificates of deposit (CDs) are federally insured bank deposits that pay a stated amount of interest for a specified period of time, such as six months, one year, 18 months, three years, five years, or 10 years. They are offered by banks, credit unions, and brokerage firms, and CDs carry FDIC or National Credit Union Administration (NCUA) protection up to $250,000 per individual.
CD interest rates are usually higher than those offered by banks on their savings and money market products. Typically, there are early withdrawal penalties (EWPs) for withdrawing money from a CD before its maturity date.
Note: Canadian banks issue what are known as Guaranteed Investment Certificates (GICs), which can carry protection from the CDIC (Canadian Deposit Insurance Corporation).
5. Preferred Shares
Preferred Shares (~Preferred Stock) are issued by corporations, but unlike common stock these securities offer a pre-set rate of return that is usually fixed. Preferred shareholders don't share the upside potential that comes from being a common equity shareholder. Distributions come in the form of dividends, as opposed to interest income.
6. Fixed Income Mutual Funds and ETFs
Mutual funds holding fixed-income securities are commonly referred to as bond funds, and represent a way for investors to invest in a diversified pool of fixed-income holdings.
Meanwhile, exchange-traded funds (ETFs) are a kind of pooled investment security similar to a mutual fund, that tracks either an index, a sector, a particular commodity, or other assets. What sets ETFs apart from mutual funds is that they are bought and sold on a stock exchange. A fixed-income ETF can contain government bonds, corporate bonds, state, and local bonds.
While the underlying instruments, the bonds themselves, have a maturity date, a bond ETF or bond fund doesn't have a maturity date. An ETF or mutual fund can exist indefinitely until the plan sponsor decides to stop supporting the issue. Investors should be aware that both ETFs and mutual funds charge management fees, typically quoted on an annualized % basis.
Benefits of Fixed Income Securities
- Diversification: fixed income investments often, but not always, move in an opposite direction to equity markets. Thus, such holdings can potentially help protect a portfolio from stock market losses.
- Capital preservation: investment in fixed income securities can help protect an investor's capital, which shouldn't be at risk unless an issuer (or guarantor) has solvency problems.
- Income generation: payments received from fixed-income investments provide a steady stream of income at regular intervals.
Risks & Limitations of Fixed Income
- Interest rate risk: when interest rates rise, bond prices fall, putting capital at risk if an investor plans on selling a bond prior to maturity.
- Purchasing power risk: bonds pay a fixed amount of interest at regular intervals. However, if this rate is less than the rate of inflation, the bondholder will losepurchasing power.
- Credit risk: if a bond issuer falls on hard times and defaults on its debt obligations, bondholders may not receive back the full value of their principal.
- Liquidity risk: if a bondholder needs to sell their fixed income asset on the open market, they may not be able to find a buyer without making a price concession.
Purchasing Fixed Income Investments
Stocks are widely traded on the secondary market via stock exchanges, but very few bonds trade in this manner. Bond trading generally occurs over-the-counter (OTC), and investors should inquire with their brokerage or bank about what bond inventory is on offer for their preferred term and type of issuer.
For U.S. government bonds, however, investors have another avenue to access these via the TreasuryDirect website.
Bond ETFs, however, can be purchased directly on stock exchanges. These ETFs will carry a ticker just like a stock would, and their market values can be monitored regularly during normal stock market hours, which are 8:30am – 4:00pm EST during weekdays in the U.S. and Canada. Some ETFs are more liquid than others, and investors should pay attention to the bid-ask spread.
Bond mutual funds can be purchased via the mutual fund provider. Many websites provide investors comparisons of various mutual funds of the same type.
Meanwhile, Certificates of Deposit are available for purchase via banks or credit unions, and some investment brokerages will facilitate purchase of CDs.
Bottom Line
Fixed income securities generally offer greater security than stocks, as well as a regular interest payments (or dividends on preferred stocks), but do not offer the same amount of upside potential as equities would. Fixed income investments are useful for those saving for a particular cause, such as a new car purchase, or those who simply have lower risk tolerance. They can also be attractive to investors who are either retired or nearing retirement and would benefit from a fixed income. Fixed income investments often provide greater predictability than stocks, especially in uncertain times. A diversified portfolio can contain a sizable allocation to fixed income investments, alongside stocks and commodities, and other asset types.
