Fixed income is an asset class that focuses on preserving an investor’s capital (initial investment) while providing a steady stream of income. This ability to provide protection and income makes it less risky than other asset classes. On the other hand, that also means you will likely see lower returns than other asset classes, like equities.
Want to learn more about what an asset class is and other types? Check out our What is an Asset Class? article.
There are a few layers to how fixed-income securities work and behave in the markets. But not to worry, we’re going to take you through the how’s, what’s and types of fixed-income investing.
How does fixed income work?
Fixed-income securities work by paying investors a fixed payment until a specified maturity date—both the payment amount and maturity date are predetermined. The payments are then typically paid out as interest. At the end of the term, investors receive back their initial investment.
For example, a government issues a 2.5% bond with a $500 face value that matures in 10 years. The investor buys the bond for $500—essentially loaning that money to the government. Over the 10 years, the investor receives an interest payment (usually monthly, quarterly or annually) based on a rate of 2.5% per year. At year 10 (the maturity date) the investor is repaid their initial investment of $500.
What are the benefits?
As we’ve seen, there are a few more components to fixed-income securities than your average investment, but that also gives the opportunity for more benefits!
Fixed-income securities work to preserve the value of the initial investment. This makes them a great tool for investors closer to retirement or with shorter investment time horizons who wouldn’t have time to make up significant losses.
Providing regular income is another reason this asset class can be an effective retirement investment tool. And it can make up for receiving lower total returns in the long run.
Considered less risky than equities, fixed income can help diversify your portfolio from stock market risk. If the markets take a tumble, your fixed-income assets could offset those losses.
While lower on the risk spectrum, there is some opportunity to increase the overall value of your investment. A company with a lower credit rating may reward its investors with a higher yield to compensate for the added risk they are taking (instead of purchasing a government bond or bonds of a company with a higher credit rating). This could result in a higher potential return.
What are the risks?
Fixed income investments are designed to minimize risk in your portfolio. However—as with any investment—there’s still a few things to consider.
Bond prices are inversely related to interest rates. So, when interest rates rise, bond prices fall. If you need to cash out your bond before the maturity date, this could mean you realize some losses.
Fixed income payments are… well… fixed. So, if the rate of inflation outpaces your payments, the value of each dollar you receive has less purchasing power.
Credit or default
Remember, a bond is like a loan, which means there’s a risk the issuer could default. Fortunately, bonds have ratings that reflect the financial strength of the issuer, so you can decide how much risk you want to take on.
Some bonds may be less liquid than traditional stocks and the difference between what you want to sell at and what buyers are willing to pay (called a spread) can be large, making it harder to get out before maturity.
Types of fixed income
Now that you know what you’re getting with your fixed income, let’s go over the different types of securities you can include in your portfolio.
The safest of the bond family, the most commonly issued government bonds are from the U.S. government (known as Treasury securities). However, other federal governments and municipalities also issue bonds.
Slightly riskier, the price and interest rates for corporate bonds are often determined by the company’s financial stability and credit rating.
These corporate-issued bonds tend to pay investors higher interest rates due to their higher risk profile and chances of default.
Fixed-income mutual funds and ETFs
Fixed-income mutual funds or ETFs give exposure to a variety of bond or debt instruments, or target specific credit ratings through professional management.
Incorporating fixed income in your portfolio
As we’ve discussed, there’s lots of benefits to investing in fixed income, from having a reliable income stream to downside protection when markets swing. Whether you want capital preservation to be the focus of your investments or if you’re looking to add some diversification to your equity holdings, we have managed portfolios that use a variety of fixed-income solutions to maximize returns at different levels of risk, and we make it easy for you to invest in a portfolio that makes sense for you.