Guide to Fixed Income: Types and How to Invest

What Is Fixed Income?

Fixed income refers to those types of investment securities that pay investors fixed interest or dividend payments until they mature. At maturity, investors are repaid the principal amount that they originally invested. Government and corporate bonds are the most common types of fixed-income products.

Unlike equities, that may pay no income to investors, or variable-income securities, where payments can change based on some underlying measure, such as short-term interest rates, the payments of a fixed-income security are known in advance and remain fixed throughout its term.

In addition to purchasing fixed-income securities directly, investors can choose from a variety of fixed-income exchange-traded funds (ETFs) and mutual funds to buy.

Understanding Fixed Income

Companies and governments issue debt securities to raise money to fund day-to-day operations and finance large projects. These fixed-income instruments pay a set interest rate return in exchange for investors lending their money. At the maturity date, investors are repaid the original amount that they invested. This amount is known as the principal.

A Company Issues a Bond

For example, a company might issue a 5% bond with a $1,000 face or par value that matures in five years. The investor buys the bond for $1,000 and will not be paid back until the end of the five years. Over the course of the five years, the company makes interest payments—called coupon payments—based on a rate of 5% per year.

As a result, the investor is paid $50 per year for five years. At the end of the five years (on the maturity date), the investor is repaid the $1,000 they invested initially. Investors may also find fixed-income investments that make coupon payments monthly, quarterly, or semiannually.

Who Fixed Income Is for

Fixed-income securities are recommended for conservative investors seeking a diversified portfolio. The percentage of the portfolio dedicated to fixed income depends on the investor's investment style. An investor might also choose to diversify their portfolio with a mix of fixed-income products and stocks, creating a portfolio of, for example, 50% fixed-income products and 50% stocks.

Treasury bonds and bills, municipal bonds, corporate bonds, and certificates of deposit (CDs) are all examples of fixed-income products. Each of these products has unique benefits and limitations as investments.

Types of Fixed Income Products

As stated earlier, the most common example of a fixed-income security is a government or corporate bond. Bonds trade over-the-counter (OTC) in the bond market and secondary market.

The most common government securities are those issued by the U.S. government and are generally referred to as Treasury securities. Fixed-income securities are offered by non-U.S. governments and corporations, as well.

Here are common types of fixed income products:

• Treasury bills (T-bills) are short-term fixed-income securities that mature within one year and that do not make coupon payments. Investors buy the bill at a price less than its face value and earn that difference at maturity.
• Treasury notes (T-notes) have maturities between two and 10 years, pay a fixed interest rate, and are sold in multiples of $100. Throughout the note's term, investors receive semiannual interest payments. At maturity, they're repaid the principal.
• Treasury bonds (T-bonds) function similarly to the T-note except that they mature in 20 or 30 years. Treasury bonds can be purchased in multiples of $100.
• Treasury Inflation-Protected Securities (TIPS) protect investors from inflation. The principal amount of a TIPS bond adjusts with inflation and deflation.
• A municipal bond is similar to a Treasury as it is government-issued, but it is issued and backed by a state, municipality, or county, instead of the federal government. It is issued to raise capital to finance local expenditures. Muni bonds can offer tax-free benefits to investors, as well.
• Corporate bonds come in various types, and the price and interest rate offered largely depend on the company’s financial stability and creditworthiness. Bonds with higher credit ratings typically pay lower coupon rates.
• Junk bonds—also called high-yield bonds—are corporate issues that pay a greater coupon due to a higher risk of default. Default occurs when a company fails to pay the principal and interest on a bond or debt security.
• A certificate of deposit (CD) is a fixed-income vehicle with maturities of less than five years offered by financial institutions. The rate is higher than a typical saving account, and CDs carry FDIC or National Credit Union Administration (NCUA) protection.
  

How to Invest in Fixed Income

Investors looking to add fixed-income securities to their portfolios have several options. Today, most brokers offer customers direct access to a range of bond markets, from Treasuries to corporate bonds to munis.

1. For those who do not want to select individual bonds, fixed-income mutual funds (bond funds) provide exposure to various bonds and debt instruments. These funds give the investor an income stream and professional portfolio management.

2. Fixed income ETFs work much like a mutual fund, but may be more accessible and more cost-effective to individual investors. These ETFs may target specific credit ratings, durations, or other factors. ETFs also carry a professional management expense.

3. Investors can also use a laddering strategy when investing in fixed income. A laddering strategy offers steady interest income that arises from investing in a series of short-term bonds with different maturities.

Then, as bonds mature, the portfolio manager reinvests the returned principal into additional short-term bonds with maturities that extend the ladder. This method provides investors with ready capital and they avoid losing out on rising market interest rates.

Laddering Example

For example, a $60,000 investment could be divided into one-year, two-year, and three-year bonds. The investor decides to invest $20,000 into each of the three bonds.

When the one-year bond matures, the $20,000 principal will be rolled into a bond maturing one year after the original three-year holding. When the second bond matures those funds roll into a bond that extends the ladder for another year, and so on. In this way, the investor receives a constant flow of interest income and can take advantage of any higher interest rates.

Example of Fixed Income

Let's say PepsiCo (PEP) issues fixed-rate bonds to fund a new bottling plant in Argentina. The issued 5% bond is available at a face value of $1,000 and is due to mature in five years. The company plans to use proceeds from the new plant to repay the debt.

You purchase 10 bonds costing a total of $10,000 and will receive $500 in interest payments each year for five years (0.05 x $10,000 = $500).

The company receives the $10,000 and uses the funds to build the overseas plant. The interest amount is fixed and gives you a steady income. Upon maturity in five years, the company pays you back the principal amount of $10,000. You earn a total of $2,500 in interest over the five years ($500 x five years).

Advantages and Disadvantages of Fixed Income

Advantages

Income Generation

Fixed-income investments offer investors a steady stream of income over the life of the bond or debt instrument. They offer the issuer much-needed access to capital or money. Steady income lets investors plan their spending, a reason these are popular products in retirement portfolios.

Relatively Less Volatile

The interest payments from fixed-income products can also help investors stabilize the risk-return in their investment portfolio—known as the market risk.

For investors holding stocks, fluctuating prices can result in large gains or losses. The steady and stable interest payments from fixed-income products can partly offset losses from the decline in stock prices. As a result, these safer investments help to diversify the risk of an investment portfolio.

Guarantees

Fixed-income investments in the form of Treasury bonds have the backing of the U.S. government.

Corporate bonds, while not insured, are backed by the financial viability of the underlying company. Should a company declare bankruptcy or liquidation, bondholders have a higher claim on company assets than do common shareholders.

Moreover, bond investments held at brokerage firms are backed by the Securities Investor Protection Corporation (SIPC) with up to $500,000 coverage for cash and securities. Fixed-income CDs have Federal Deposit Insurance Corporation (FDIC) protection up to $250,000 per individual.

Disadvantages

Although there are many benefits to fixed income products, as with all investments there are risks that investors should be aware of before purchasing them.

Credit and Default Risk

As mentioned earlier, Treasuries and CDs have protection through the government and FDIC. When choosing a corporate bond investment, look at the credit rating of the bond and the underlying company to size up the risk of default. Bonds with ratings below BBB are of low quality (meaning your risk of loss is higher) and are considered junk bonds.

The credit risk linked to a corporation can have varying effects on the valuations of the fixed-income instrument leading up to its maturity. For example, if a company is struggling financially, the prices of its bonds on the secondary market might decline in value.

If an investor tries to sell a bond of a struggling company, the bond might sell for less than the face or par value. Also, liquidity could be an issue. That is, the bond may become difficult for investors to sell in the open market at a fair price or at all because there's no demand for it.

The prices of bonds can increase and decrease over the life of the bond. If the investor holds the bond until its maturity, the price movements are immaterial since the investor will be paid the face value of the bond upon maturity.

However, if the bondholder sells the bond before its maturity through a broker or financial institution, the investor will receive the current market price at the time of the sale. The selling price could result in a gain or loss on the investment depending on the underlying corporation, the coupon interest rate, and the current market interest rate.

Interest Rate Risk

Fixed-income investors might face interest rate risk. This is the risk that, in an environment where market interest rates are rising, the rate paid by the bond falls behind. And in such a case, the bond would lose value in the secondary bond market (with bonds, when rates rise, prices fall). Also, the investor's capital is tied up in the investment, and they cannot put it to work earning higher income without taking an initial loss.

For example, if an investor purchased a two-year bond paying 2.5% per year and interest rates for 2-year bonds jumped to 5%, the investor is locked in at 2.5%. For better or worse, investors holding fixed-income products receive their fixed rate regardless of where interest rates move in the market.

Inflationary Risk

Inflationary risk is also a danger to fixed-income investors. The pace at which prices rise in the economy is called inflation. If inflation increases, it eats into the gains of fixed-income securities. For example, if fixed-rate debt security pays a 2% return and inflation rises by 1.5%, the investor loses out, earning only a 0.5% return in real terms.

Fixed-Income Analysis: What to Consider

When deciding which of these financial products to invest in, many investors perform fixed-income analysis. Such analysis can help you to evaluate which investments make the best sense for your investment profile.

The Importance of Risk

For example, fixed-income analysis often begins with risk. Every investment has a relationship between risk and its return. All else being equal, an investment's returns should be higher when the investment is riskier.

Therefore, fixed-income analysis not only assesses whether an investor is comfortable with the level of risk they are taking on but whether the level of risk is appropriate for a fixed income security's return.

For fixed-income securities, risk is tied to the creditworthiness of the issuing company, term of the fixed income security, and industry in which the company participates in. For example, you'll often find the lowest return fixed-income securities are issued by the U.S. government.

Because risk of default is low, U.S. bonds are often seen as safe forms of investments. On the other hand, corporations (especially ones with cash flow problems) may pose greater risk but offer higher returns.

Some fixed income securities offer periodic payments. This allows investors to recoup funds during the duration of the investment. This also reduces risk, as not all capital needs to be returned at the end of a potentially long bond term.

Lastly, different fixed income securities have different features that make them more or less appealing. Some may be callable, which means the debtor can repay the full bond prior to maturity. Others allows for the fixed income security to be converted to common stock.

It's critical to be aware of such features because they can reduce an investor's yield if acted upon.

The Bottom Line

Fixed income refers to a fixed rate of interest paid by debt securities, along with the return of the principal. Fixed-income securities include different types of bonds and certificates of deposit.

Fixed income as an asset class is generally less volatile than equities (stocks), and is considered to be more conservative. A well-diversified portfolio should have some allocation of fixed income. For some investors, this allocation increases as their investment time horizon shortens (e.g., as retirement approaches).