A fixed-income security is an investment that offers returns through regular interest payments and the return of principal at maturity. These securities provide predictable returns, unlike variable-income securities, where payments vary due to underlying measures like short-term interest rates.
Key Insights
- Fixed-Income securities grant investors fixed periodic interest payments and return the principal at maturity.
- Bonds represent the most common type of fixed-income security, varying in term length and purpose from the issuer’s standpoint.
- Rating agencies evaluate bonds and assign credit ratings that reflect the issuer’s financial stability.
- U.S. Treasury fixed-income securities are ultra-low risk, backed by the U.S. government’s credit.
Understanding Fixed-Income Securities
Fixed-income securities, primarily in the form of bonds, provide investors with fixed interest payments at regular intervals, often semiannually. At the end of the bond’s term (maturity), the principal is returned to the investor. Corporations and governments commonly issue bonds to raise funds for various projects. These can have different face values and maturities and are generally traded over-the-counter (OTC).
Credit Rating of Fixed-Income Securities
Bonds carry credit ratings that indicate the issuer’s ability to meet financial obligations. These ratings, performed by credit-rating agencies, offer insight into potential investment risks. There are two primary categories:
- Investment-grade bonds: Issued by entities with low default risk, these bonds offer lower interest rates.
- Non-investment-grade bonds (junk bonds): These higher-risk bonds come with higher interest rates due to the elevated risk of default.
Variety of Fixed-Income Securities
Treasury Notes (T-Notes)
T-Notes, issued by the U.S. Treasury, are intermediate bonds maturing in 2, 3, 5, 7, or 10 years. They pay semiannual interest and are backed by the U.S. government.
Treasury Bonds (T-Bonds)
T-Bonds have long maturities of 20 or 30 years, also backed by the U.S. government.
Treasury Bills (T-Bills)
T-Bills are short-term securities maturing in up to 52 weeks. They are sold at a discount and do not pay interest; instead, the interest is the difference between the purchase price and the face value.
Municipal Bonds
Municipal bonds finance community projects and offer tax-exempt interest income. They typically mature at various intervals over time.
Certificates of Deposit (CDs)
Issued by banks, CDs pay interest on deposited funds over set terms. They often offer higher rates than traditional savings accounts but come with lower liquidity than bonds.
Corporate Bonds
Companies issue these bonds to raise funds, differentiated by their maturities as short-term, medium-term, or long-term. Investment or non-investment grade designations depend on the issuer’s financial health.
Preferred Stock
Preferred stocks promise fixed dividends and are sensitive to interest rates, often yielding more than typical bonds.
Benefits and Drawbacks of Fixed-Income Securities
Advantages
- Reliable Income: Fixed-income securities provide stable investment returns.
- Portfolio Diversification: They help reduce overall investment portfolio risk.
- Mitigate Volatility: Typically less volatile than stocks.
- Government-Backed Safety: U.S. Treasury securities are extremely low-risk.
Dilemmics
- Lower Returns: Tend to offer lower return rates compared to equities.
- Interest Rate Risk: Market interest rate shifts can affect bond prices and profitability.
- Inflation Impact: High inflation can erode the real value of returns.
- Default Risk: Credit or default risk exists if the issuer fails to meet payments.
Real-Life Scenario
- Long-Term Investment: A 30-year Treasury bond issued on March 15, 2024, with an annual return rate of 4.250% provides regular interest payments and return of principal after 30 years.
- Medium-Term Investment: A 10-year Treasury note issued on the same date offers a 4.000% annual rate, providing predictable annual payouts until maturity.
Investing in Fixed Income Securities
Consumers may purchase government fixed-income instruments via TreasuryDirect, whereas corporate bonds and bond funds are accessible through brokers. CDs can be bought from both banks and brokers.
Risks of Investing in Fixed Income Instruments
Investing in fixed income requires long-term commitments, but bonds can be sold before maturity, allowing gains or losses based on market conditions. Interest rate changes influence the value; rates increase can decrease bond prices and vice versa. Inflation and issuer defaults are other critical factors to consider.
What is Default in Fixed-Income Securities?
Default means missing mandatory interest or principal payment schedules, affecting loans and investment securities issued by individuals, businesses, or sovereign states.
Conclusion
Fixed-income securities offer steady, reliable income streams with lower volatility. Available options like government bonds, corporate bonds, and CDs diversify investment portfolios. However, prospective investors should assess risks, such as interest rate fluctuations, inflation impact, and credit default possibilities, before committing.
Related Terms: bonds, interest rate, investment grade, default risk, credit rating.
References
- Treasury Direct. “Treasury Notes”.
- Treasury Direct. “About Treasury Marketable Securities”.
- Treasury Direct. “Treasury Bonds”.
- Treasury Direct. “Treasury Bills”.
- E*TRADE. “The Basics of Municipal Bonds”.
- FDIC. “Deposit Insurance FAQs”.
- U.S. Securities and Exchange Commission. “What Are Corporate Bonds?”
