Finance

What is a fixed income?

By: Dale Arasa - @inquirerdotnet

Inquirer Los Angeles / 11:07 AM March 03, 2021

When you read “What is a fixed income?” you probably thought we were referring to employment. However, we were talking about fixed-income investments. Investors purchase them to receive a set amount every year. After a few years, the fixed income products mature, and the investors get back the principal amount.

We’ll begin by defining fixed-income investments. Then, we’ll elaborate on the investment types available. Afterward, we’ll proceed with the potential benefits of fixed income securities alongside the possible risks of investment options. Finally, we’ll recommend the ideal investment strategy.

Understanding fixed-income investments help you improve your investment strategy. Conservative investors could find another way to earn a slow but steady income. In contrast, it may serve as a safety net for the more courageous investors. If you haven’t started investing, these could serve as your first baby steps!

What is a fixed income?

Fixed income generally refers to investment securities that provide fixed dividends or interest payments. After a defined maturity date, investors receive the original amount they invested.

These are also referred to as debt securities or fixed-income securities. It’s because they generate a fixed flow of income from interest payments.

Moreover, conservative investors often swear by fixed income investments. After all, they earn safe long-term yields from these financial products.

Depending on your debt security, you virtually have no risk of losing money. However, fixed income securities are far from perfect.

Stocks vs fixed income

Every investment option has its pros and cons, including fixed income. Compared to stocks, they generate meager returns that remain constant throughout the debt security’s life.

Depending on company performance, stock value may increase. Of course, you could lose money if the business doesn’t do well.

Furthermore, you may earn from stocks as long as the company remains open. On the other hand, you stop earning from fixed income once the maturity date comes.

Selling fixed income investments

Similar to stocks, you could sell fixed income products before they mature. The market price depends on multiple factors, such as interest rate risk.

In turn, you’ll receive an amount different from its original face value or “par value.” You may sell it at a higher price, but the buyer will have a lower yield to maturity.

Moreover, you’ll have to pay a “markdown” to your broker. It’s a portion that brokers deduct from the sales price to cover the transaction cost and profit.

Types of fixed income

There’s a wide selection of fixed income products available. Note that there are other fixed income products that we might not have discussed:

Certificates of deposit (CD)
Bonds
Bond funds
Money market funds
Annuities

These options have their perks and quirks, so none of them are perfect. Match the viable choices with your investment strategy.

Certificates of deposit (CD)

These allow you to save money at a fixed interest rate for a certain period. They’re also known as time deposits.

You start by purchasing these certificates of deposit. Then, you must leave your money until the maturity date. Before the deadline, you receive payment typically twice a year.

Banks and credit unions provide regular CDs. On the other hand, brokerage firms grant their options.

Recently, a new type called equity-indexed CDs has emerged. However, most investors frown upon them and prefer the classic certificate of deposit instead.

Bonds

Purchasing bonds means lending to your government, municipality, or corporation. Hence, the bond market options can be classified according to their issuers.

As the name suggests, private businesses 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’re also high-risk since its issuer might not be able to pay principal nor interest.

Local governments issue municipal bonds. Meanwhile, the US Department of the Treasury issues government bonds like treasury bills, treasury bonds, and t-notes.

Bond funds

It’s a type of investment company that invests mainly in bonds and other fixed income securities. Bond funds also refer to mutual funds, bond ETFs, and unit investment trusts (UIT).

Some people believe that bond funds pose no risk whatsoever. Contrary to popular belief, investors may lose money in bond funds due to multiple factors.

What’s more, there are ultra-short funds, investments for debt securities with too short maturities. Investors should watch out for the higher risk compared to other investments, though.

Money market funds

Similar to bond funds, these invest in short-term debt securities. The brief maturity may limit uncertainty and risk so that investors may gain quick yet meager returns.

Just like how bonds mature, money market funds also pay dividends periodically. Moreover, they’re usually liquid, meaning you may receive funds after a few business days.

Unfortunately, market turmoil may cause them to become illiquid. Worse, you may lose your principal. The government doesn’t back them, so expect handling market losses alone.

Annuities

These fixed income products are contracts between investors and insurance companies. They ensure income periodically for the rest of your life!

You may choose fixed-rate annuities that guarantee interest rates of around 5%. On the other hand, variable-rate annuities pay based on how your option performs.

However, their interest payments are far smaller compared to other securities. Worse, the scant returns are offset further by numerous fees. Some investors might find them worthwhile, though.

Benefits of fixed income

All investments have their potential benefits and risks. The key to successful investing is finding out which ones best suit your strategy.

Most investors swear by the well-rounded portfolios. They don’t limit themselves to one kind of investment. However, your portfolio mix will entirely depend on you.

As a result, they often include fixed income securities along with their stocks. Their benefits go beyond the safe and steady gains:

1. Diversification – Most people invest in the stock market. However, it’s subject to numerous factors such as business performance and economic downturns. Fixed income investments allow them to cushion potential stock market losses.
2. Capital preservation – Retirees may replace the volatility of stocks for the assurance of fixed income securities. However, be mindful of possible inflation risk.
3. Income generation – Securities could serve as passive income while you work for active income. What’s more, municipal bonds are tax-exempt.
4. Total return – Some fixed income investments could produce high-yields. It’s up to investors to seek them out and take their chances.

Risks of fixed income

Contrary to popular belief, risk-free investments still come at a cost. Remember that all financial products entail some sort of trade-off. Everything has a price, monetary or otherwise.

1. Interest rate risk – During economic downturns, 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 causes your periodic payments to lose purchasing power.
3. Credit risk – It’s also called business risk or financial risk. Credit risk is the likelihood that an issuer might default on its debts. As a result, investors may not receive the full principal at maturity. Junk bonds especially have a higher risk of default.
4. Liquidity risk – Let’s say you want to sell your fixed income asset. If it has a high liquidity risk, you might struggle to find a buyer.

Should you invest?

We’ve covered fixed income investments extensively, but there are more options besides our recommendations. All the choices available in money markets won’t fit in one article!

As we’ve mentioned, you should invest based on your investment objectives. People usually go for a conservative or radical approach to their investments.

Fixed-income assets are more suitable for investors who want consistent returns. If you value financial security, this might be the ideal choice.

Conversely, you may earn more from alternative investments preferred stocks. If you’re willing to lose some money for potentially more enormous gains, fixed income products might not be for you.

Furthermore, you should keep updated with the latest finance and economic news. Everything changes rapidly and continuously, so your strategy must adapt quickly.

For example, you may want to heed Warren Buffett’s latest disapproval for bonds. Also, the coronavirus gave rise to new financial products like pandemic bonds.