What is Fixed Income?
Fixed income broadly refers to those types of investment securities that pay investors fixed interest or dividend payments until their maturity date. At maturity, investors are repaid the principal amount they had invested. Government and corporate bonds are the most common types of fixed-income products.
Unlike equities that may pay out no cash flows 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.
In addition to purchasing fixed-income securities directly, there are several fixed-income exchange-traded funds (ETFs) and mutual funds available to investors.
Key Takeaways
- Fixed income is a class of assets and securities that pay out a set level of cash flows to investors, typically in the form of fixed interest or dividends.
- Government and corporate bonds are the most common types of fixed-income products.
- They are known as fixed income because they pay a fixed interest rate credited to investors.
- At maturity for many fixed income securities, investors are repaid the principal amount they had invested in addition to the interest they have received.
- In the event of a company’s bankruptcy, fixed-income investors are often paid before common stockholders.
Understanding Fixed Income
Companies and governments issue debt securities to raise money to fund day-to-day operations and finance large projects. For investors, 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 they had invested—known as the principal.
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 pays 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, the investor is repaid the $1,000 invested initially on the maturity date. Investors may also find fixed-income investments that pay coupon payments monthly, quarterly, or semiannually.
Investing in Fixed Income
Fixed-income securities are recommended for conservative investors seeking a diversified portfolio. Treasury bonds and bills, municipal bonds, corporate bonds, and certificates of deposit (CDs) are all examples of fixed-income products. Bonds trade over-the-counter (OTC) on the bond market and secondary market.
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. For those who do not want to select individual bonds, fixed-income mutual funds or bond ETFs provide diversified exposure to various bonds and debt instruments, allowing for an income stream with professional management.
Fixed-income investing is generally a conservative strategy where returns are generated from low-risk securities that pay predictable interest. Building a fixed income portfolio may include investing in bonds, bond mutual funds, and certificates of deposit (CDs).
Types of Fixed Income Products
Here are the most common types of fixed income products:
- Treasury bills (T-bills) are short-term fixed-income securities that mature within one year that do not pay coupon returns. Investors buy the bill at a price less than its face value and earn the difference at maturity.
- Treasury notes (T-notes) come in maturities between two and 10 years, pay a fixed interest rate, and are sold in multiples of $100. At the end of maturity, investors are repaid the principal and earn semiannual interest payments until maturity.
- Treasury bonds (T-bonds) are similar to T-notes except that they mature in 20 or 30 years.
- Treasury Inflation-Protected Securities (TIPS) protect investors from inflation. The principal adjusts with inflation and deflation.
- A municipal bond is issued and backed by a state, municipality, or county, and is used to raise capital to finance local expenditures. Muni bonds can have 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 the higher risk of default.
- A certificate of deposit (CD) is a fixed income vehicle offered by financial institutions with maturities of less than five years. CDs carry FDIC or NCUA protection.
Advantages of Fixed Income
Income Generation
Fixed-income investments offer investors a steady stream of income over the life of the bond or debt instrument while simultaneously offering the issuer much-needed access to capital or money. Steady income lets investors plan for 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 market risk. For investors holding stocks, prices can fluctuate resulting 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.
Guarantees
Fixed-income investments in the form of Treasury bonds (T-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 common shareholders. Moreover, bond investments held at brokerage firms are backed by the Securities Investor Protection Corporation (SIPC). Fixed income CDs have Federal Deposit Insurance Corporation (FDIC) protection.
Risks Associated With Fixed Income
Credit and Default Risk
Corporate debt, while less secure, still ranks higher for repayment than shareholders. Always look at the credit rating of a bond and the underlying company. Bonds with ratings below BBB are of low quality and considered junk bonds.
Interest Rate Risk
Fixed-income investors might face interest rate risk. This risk happens in an environment where market interest rates are rising, and the rate paid by the bond falls behind. In this case, the bond would lose value in the secondary bond market.
Inflationary Risks
Inflationary risk is another danger. If prices rise or 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 earns only a 0.5% return in real terms.
Fixed Income Pros and Cons
Pros
- Steady income stream of fixed returns
- More stable returns than stocks
- Higher claim to assets in bankruptcies
- Government and FDIC backing on some
Cons
- Returns are often lower than other investments
- Credit and default risk exposure
- Susceptible to interest rate risk
- Sensitive to inflationary risk
Some government bonds like Treasury Inflation-Protected Securities (TIPS) are indexed to changes in the inflation rate and protect investors accordingly.
Fixed Income Analysis: What to Consider
When deciding which of these financial products to invest in, fixed income analysis should be conducted. Consider the creditworthiness of the issuer, the length of the security, and its yield. Bonds from governments like the U.S. are seen as safer due to the low risk of default, whereas corporate securities can be riskier. It’s crucial to assess whether the returns justify the level of risk taken.
A laddering strategy offers steady interest income through the investment in a series of short-term bonds. As bonds mature, the principal is reinvested into new short-term bonds, extending the ladder, offering regular income and capital accessibility.
Example of Fixed Income
To illustrate, let’s say PepsiCo issues a 5% bond with a $1,000 face value due to mature in five years for a new bottling plant. You purchase 10 bonds for a total of $10,000 and receive $500 in interest payments each year for five years. Upon maturity, you’re repaid the $10,000 principal.
Bottom Line
Fixed income refers to investments that pay a fixed interest rate along with the principal at maturity. They encompass various types of bonds and CDs, and are generally conservative investments. An optimized portfolio should allocate to fixed income, especially as retirement nears.
Related Terms: fixed-rate bonds, corporate bonds, junk bonds, municipal bonds, laddering strategy.
References
- U.S. Department of the Treasury, Bureau of the Fiscal Service. “Treasury Bills”.
- U.S. Department of the Treasury, Bureau of the Fiscal Service. “Treasury Notes”.
- U.S. Department of the Treasury, Bureau of the Fiscal Service. “Treasury Bonds”.
- U.S. Department of the Treasury, Bureau of the Fiscal Service. “Treasury Inflation-Protected Securities (TIPS)”.
- U.S. Securities and Exchange Commission. “Investor Bulletin: Municipal Bonds – An Overview”.
- Federal Deposit Insurance Corporation. “Deposit Insurance FAQs”.
- National Credit Union Administration. “Share Insurance Fund Overview”.
- Financial Industry Regulatory Authority. “U.S. Treasury Securities”.
- U.S. Securities and Exchange Commission, Office of Investor Education and Advocacy. “What Are Corporate Bonds?”, Page 1.
- Fidelity. “Bond ratings”.
