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Fixed income investing is a lower-risk investment strategy that focuses on generating consistent payments from investments such as bonds, money market funds, and certificates of deposit or CDs. Many people shift their portfolios to a fixed-income approach as they approach retirement, as they may rely on their investments for regular income.
Although fixed income assets are generally less risky than investing in growth-oriented assets such as equities, the approach is not without risk. Here’s what you need to know about fixed income investing.
How fixed income investments work
Investing with fixed income securities is aimed at offering you a consistent – fixed – cash flow. Suppose you decide that you are comfortable putting $10,000 into a fixed-income investment. Here are some key things you will look for when researching fixed rate investments:
- interest rates on a range of different products
- the timeline for when they will pay you
- their due dates for when you can get your principal back
- the chance that you will be reimbursed
Do you want to get your original €10,000 back within a year? Three years? Or do you want to keep that money for an even longer period? How often would you like to be paid during that time? These are the types of questions you will ask.
Once you identify your specific needs, invest your money and use these regular interest payments to cover your expenses.
Is investing in fixed income securities suitable for you?
Investing in fixed income can be an especially good option if you live on a fixed income and are looking for ways to maximize your savings. And if you’re worried about the wild ups and downs of the stock market, investing in fixed income can help you sleep a little better at night.
“Fixed income investments can provide a degree of stability, especially for investors who hold such investments for their income-producing potential and do not actively trade based on price changes,” says Elliot Pepper, CPA, financial planner and co-founder of Maryland. established Northbrook Financial. “Investors who are less concerned about capital growth or less tolerant of large market swings may be better served in a portfolio that offers the predictable returns from a stream of income payments.”
Fixed income investments are often combined with equity investments to create a more diversified portfolio with lower risk. Fixed income securities provide stability and regular cash flow, while equity investments offer growth over time, albeit at the expense of volatility. So a good investor can design a portfolio with both elements to meet his short- and long-term needs.
“We typically consider an investor’s time horizon and risk tolerance to determine the right balance between more conservative fixed income investments versus more aggressive equities or other investments,” says Pepper.
What are examples of investing in fixed income securities?
If you are considering fixed income investments, you can choose from a wide range of products.
Federal government bonds: The federal government needs to raise capital and therefore issues a range of fixed-income investments such as government bonds, government bonds and government bonds. They have a wide range of terms (as little as four weeks and as long as 30 years), and most of them make regularly scheduled payments of accrued interest, known as coupons. Treasury bills pay the interest and return the principal at the end of the term.
“Typically, U.S. Treasury bonds are given the ‘safest’ label when it comes to default risk,” says Pepper.
Municipal bonds: City, county and state governments also need capital to cover the costs of major projects such as a new highway or new schools. These are also fairly safe investments, but there are still risks of default. One advantage of municipal bonds is that they are typically tax-free in the state in which they are issued and free from federal taxes, potentially providing more attractive returns.
Corporate bonds: As companies try to grow, they need money, and corporate bonds can be a win-win for the companies that get capital and the bondholders that earn regular income. However, it is important to note that some companies are much healthier financially than others. Make sure you understand how a company generates cash flow from its operations, as that is likely how it will pay interest on its bonds. If the company gets into financial trouble and cannot make payments to bondholders, you could lose some or all of your investment.
“Bonds issued by certain companies with low credit ratings, also known as ‘junk bonds,’ carry higher interest rates,” says Pepper, “but the risk of default is much greater.”
Certificates of Deposit (CDs): Certificates of deposit are available from banks and credit unions, and those financial institutions will pay a premium for your willingness to park your money for an extended period of time – anywhere from three months to five years or more. Instead of having easy access to your money in a savings account, a CD typically requires you to pay a penalty if you want to receive your principal before the due date.
Money Market funds: Money market funds are a type of mutual fund that invests in short-term debt securities such as CDs, government bonds and other forms of short-term corporate debt. They can provide a liquid source of money, but their returns will fluctuate depending on prevailing interest rates.
Advantages and disadvantages of investing in fixed income securities
Plus points
1. Can protect you during market turbulence
Do you remember the stock market plunge of 2020? Casey T. Smith, president of Georgia-based Wiser Wealth Management, says this kind of “major market sell-off” can serve as a reminder of how positive fixed-income investing can be. Smith adds that “there is no cheaper hedge for the stock market than U.S. Treasury bonds.”
That hedge can be especially important if you’re retired and looking for ways to earn an income while dealing with the short-term anxiety of market fluctuations.
“In theory, in retirement, to get great long-term returns, all you need to do is keep enough money to cover your expenses for a few years, and then invest in broad core indexes like the S&P 500,” says Smith.
“Realistically, however, retired investors cannot tolerate that much volatility and would end up selling shares and then buying them back at the worst times,” he says. “Rather than fighting human nature to make bad investment decisions, add bonds to portfolios to smooth out short-term volatility. The idea is that if you… [have a portfolio of] 50 percent bonds, then you take on half the market risk.”
2. Stable returns
If you’re trying to plan your expenses for retirement, knowing exactly how much money you’ll generate from fixed income investing can simplify your budgeting. You know exactly how much money is coming in from your investments and can plan around that income.
3. Potential tax benefits
Some fixed-income investments have positive consequences when it comes time to pay your annual bill to the government. For example, interest income from U.S. Treasury bonds is exempt from state and local income taxes, and income from municipal bonds is not subject to federal taxes.
Cons
1. Potentially lower returns
Because of their relative safety, fixed income investments generally provide lower returns than riskier investments such as stocks. And that means you may miss out on the potentially much higher returns from equities.
That’s one of the challenges of risk avoidance. These uncertain equity investments can ultimately yield much more than a fixed coupon payment. But ultimately, the type of investment you choose will depend on your circumstances and risk tolerance.
2. Interest rate risk
“The biggest disadvantage we typically see with fixed income is interest rate risk,” says Pepper.
The rule with bonds is that when interest rates rise, bond prices fall. Suppose you paid $2,000 for a bond with a ten-year term and an interest rate of 3 percent. After holding the bond for three years, the interest on a new 10-year bond is 4 percent. If you want to sell your bond early, you are competing with products with better earning potential, which will make the bond worth less.
Some fixed-income products, such as bank CDs, won’t see a price drop, but you may have to pay a penalty if you close the CD early.
3. Problems accessing cash
Keep in mind that getting the money you have in fixed income investments isn’t as simple as withdrawing money from your savings account. For example, if you put your money in a five-year CD and need that deposit two years later, you’ll likely have to pay a penalty.
If you need to sell a bond before maturity and interest rates have risen, you may be forced to sell at a loss because the market will reprice the bond based on current interest rates.
In short
Fixed income investments can provide some valuable stability to a mostly stock portfolio, and it’s one reason financial advisors include them in investors’ portfolios. Fixed income helps reduce volatility while providing a steady stream of cash flow, a feature that is especially valuable for older Americans who need the security of a regular income.
