When you read “What is fixed income?” You probably thought we were referring to employment. However, we were talking about fixed income investments. Investors buy them to receive a fixed amount each year. After a few years, bond products mature and investors recover the capital.
We’ll start by defining fixed income investments. Next, we will detail the types of investments available. Next, we will discuss the potential benefits of fixed income securities as well as the possible risks of investment options. Finally, we will recommend the ideal investment strategy for you.
Understanding fixed income investing helps you improve your investment strategy. Cautious investors might find another way to earn slow but steady income. On the other hand, it can serve as a safety net for the bravest investors. If you haven’t started investing, these could be your first steps!
What is fixed income?
Fixed income generally refers to investment securities that provide fixed dividends or interest payments. After a set maturity date, investors receive the initial amount they invested.
These are also called debt securities or fixed income securities. This is because they generate a fixed stream of income from interest payments.
Plus, conservative investors often swear by fixed income investments. After all, they derive secure long-term returns from these financial products.
Depending on how secure your debt is, you have virtually no risk of losing money. However, fixed income securities are far from perfect.
Equities vs Fixed Income
Each investment option has its pros and cons, including fixed income. In relation to actions, they generate meager returns that remain constant throughout the life of the debt instrument.
Depending on the performance of the company, the value of the shares may increase. Of course, you could lose money if the business is not doing well.
Additionally, you can earn shares as long as the business remains open. On the other hand, you stop earning fixed income money once the due date comes.
Sell fixed income investments
As with stocks, you can sell fixed income products before they expire. The market price depends on several factors, such as interest rate risk.
In turn, you will receive an amount different from its original face value or “face value”. You can sell it for a higher price, but the buyer will have a lower return at maturity.
What’s more, you will have to pay a “markdown” to your broker. This is a portion that brokers deduct from the sale price to cover the cost and profit of the transaction.
Types of fixed income
There is a wide selection of fixed income products. Note that there are other fixed income products that we may not have discussed:
- Certificates of deposit (CD)
- Bond funds
- Money market funds
These options have their advantages and quirks, so none of them are perfect. Match viable choices to your investment strategy.
Certificates of deposit (CD)
These allow you to save money at a fixed interest rate for a certain period. They are also called term deposits.
You start by purchasing these certificates of deposit. Then you have to leave your money until the due date. Before the deadline, you usually receive payment twice a year.
Banks and credit unions regularly provide CDs. On the other hand, brokerage firms grant their options.
Recently a new type called Equity indexed CDs emerged. However, most investors disapprove of them and prefer the classic certificate of deposit instead.
Buying bonds means a loan to your government, municipality or business. Thus, bond market options can be classified according to their issuers.
As the name suggests, private companies issue corporate bonds. Their interest rates and prices depend on a company’s creditworthiness and financial stability.
They also issue junk bonds or high yield bonds. However, they also present a high risk, as its issuer might not be able to pay the principal and the interest.
Local governments issue municipal bonds. During this time, the US Department of the Treasury issues government bonds such as treasury bills, treasury bills, and commercial paper.
Some believe that bond funds are risk free. Contrary to popular belief, investors can lose money in bond funds due to several factors.
In addition, there are ultra-short funds, investments for debt securities with too short maturities. Investors should however be careful of the higher risk compared to other investments.
Money market funds
Similar to bond funds, they invest in short-term debt securities. The short maturity can limit uncertainty and risk so that investors can get quick but meager returns.
Just like the maturity of bonds, money market funds also pay dividends periodically. In addition, they are generally liquid, which means that you can receive funds after a few business days.
Unfortunately, market turmoil can make them illiquid. Worse, you risk losing your capital. The government is not supporting them, so expect to deal with market losses on your own.
These fixed income products are contracts between investors and insurance companies. They provide income periodically for the rest of your life!
You can choose fixed rate annuities that guarantee interest rates of around 5%. On the other hand, variable rate annuities pay based on the performance of your option.
However, their interest payments are much lower compared to other securities. Worse, the meager returns are still offset by many costs. Some investors may find them useful, however.
Benefits of Fixed Income
All investments have their potential benefits and risks. The key to successful investing is finding the ones that best suit your strategy.
Most investors swear by well-balanced portfolios. They are not limited to just one type of investment. However, the composition of your portfolio will be entirely up to you.
As a result, they often include fixed income securities with their stocks. Their benefits go beyond safe and consistent gains:
1. Diversification – Most people invest in the stock market. However, it is subject to many factors such as business performance and economic downturns. Fixed income investments allow them to cushion potential losses in the stock markets.
2. Preservation of capital – Retirees can substitute the volatility of stocks for fixed income insurance. However, be aware of the possible risk of inflation.
3. Income generation – Securities could serve as passive income while you are working for active income. What else, municipal bonds are tax exempt.
4. Total return – Certain fixed income investments could produce high returns. It’s up to investors to seek them out and try their luck.
Risks Relating to Fixed Income Securities
Contrary to popular belief, risk free investing still comes at a cost. Remember that all financial products involve some kind of compromise. Everything has a price, monetary or otherwise.
1. Interest rate risk – During an economic downturn, interest rates rise and bond prices may fall. In turn, your bonds could lose value.
2. Inflation risk – Inflation is another result of depressions or recessions. This results in a loss of purchasing power from your periodic payments.
3. Credit risk – It is also called commercial risk or financial risk. Credit risk is the probability that an issuer will default on its debts. Therefore, investors may not receive all of the principal at maturity. In particular, junk bonds present a higher risk of default.
4. Liquidity risk – Let’s say you want to sell your fixed income asset. If it has high liquidity risk, you might have a hard time finding a buyer.
Should we invest?
We’ve covered fixed income investments extensively, but there are options other than our recommendations. All the choices available in the money markets do not fit in one article!
As we mentioned, you need to invest according to your investment goals. People generally take a conservative or drastic approach to their investments.
Fixed income assets are best suited for investors looking for consistent returns. If you value financial security, this might be the perfect choice.
Conversely, you can earn more through preferred shares of alternative investments. If you’re willing to lose money for potentially bigger payouts, fixed income products might not be for you.
Plus, you need to keep up to date with the latest financial and economic news. Everything changes quickly and continuously, so your strategy must adapt quickly.
For example, you might want to consider Warren Buffett’s latest disapproval of bonds. Also, the coronavirus gave birth to new financial products such as pandemic bonds.
You can choose from several fixed income investments. Each responds to different investor appetites for potential gains.
You should continue to educate yourself about the investment options. For more information, visit the Financial Sector Regulatory Authority (FINRA) website.
Nonetheless, financial literacy remains a priority. Everyone should know how to properly manage their spending and savings accounts.
Check more personal finance advice on the Internet to learn more about money management.