What are fixed-income investments?
We shed light on what fixed-income investing is, from investment types to pros and cons, strategies, price changes, and more.
Summary
Fixed-income investments offer a fixed income stream through interest or dividends.
Fixed-income investments are lower risk.
There are pros and cons of these investment options.
What does fixed-income investing mean?
If you have only recently started exploring investment options, you’re probably asking the question, “What does fixed-income investing mean?” Thankfully, the answer isn’t complicated.
The term refers to an investment approach that sees you put your money in low-risk assets that offer a fixed income stream through dividends or interest. You can use this approach to earn passive income, for capital preservation, and to reduce market risk.
For example, you can buy government or corporate bonds that pay a fixed interest rate. At maturity for many securities, you will be repaid the principal amount you invested as well as the interest you received.
What are the different types of fixed-income investments?
While government or corporate bonds arguably are the most common, they are not the only types of fixed-income investments. Those issued by the US government (known as Treasury securities) are the most common government securities. The most common fixed-income examples include:
Treasury bills (T-bills): These short-term fixed-income securities mature within one year and do not pay coupon returns. You can buy the bill at a discounted price and earn the difference at maturity.
Treasury notes (T-notes): These securities pay a fixed interest rate, are sold in multiples of $100, and reach maturity between two and 10 years after purchase. You will earn semiannual interest payments until maturity and then be repaid the principal at maturity.
Treasury bonds (T-bonds): Similar to T-notes, T-bonds are sold in multiples of $100, and they mature in 20 or 30 years.
Corporate bonds: Available in different types, the price and interest rate of these fixed-income investments depend mostly on the company’s creditworthiness and financial stability. Bonds with higher credit ratings usually pay lower coupon rates.
Certificate of deposit (CD): Financial institutions offer these fixed-income vehicles with maturities of less than five years. In addition to carrying FDIC or National Credit Union Administration (NCUA) protection, CDs offer higher interest rates than typical savings accounts.
How do fixed-income investments work?
Now that we’ve glanced at a few common fixed-income examples, let’s take a closer look at how they work.
Fixed-income investments have what are known as the coupon and the face value. These elements form only a part of total returns. The price of your investments will rise and fall as shares do when they start trading on the secondary market. They will either trade at a premium or discount to their par value.
For example, let’s say a company raises $10 million through selling fixed-income investments with a $1,000 par value. These investments pay a fixed coupon of 5% per year, and they will mature in 10 years. You will receive $50 interest each year before the par value of $1,000 is repaid at the end of 10 years. This means you receive $500 in interest over the investment period.
If you pay $900 for the investment, and the market value rises and falls after it starts trading, you will still receive $50 a year in interest based on the par value. However, the yield is calculated as the interest ($50) divided by the market value ($900), which is 5.6% instead of 5%. The opposite can happen if the market value rises above the investment’s par value.
Does the price of fixed-income investments change?
The short answer is yes; prices can change, often because of interest rates or other factors.
If the prevailing interest rate rises above the investment’s coupon rate, it will be a less attractive option for investors who can get a better interest rate elsewhere. The reduced demand for that specific option will result in a reduced price and increased yield. Inflation can also impact investment prices. Other factors that can affect fixed-income investment prices include:
Credit ratings: A credit rating downgrade leading to a higher risk of default will reduce demand until the price drops to a level where the yield compensates investors for the higher risk.
Market conditions: Stock market downturns usually lead to increased demand for defensive assets such as fixed-income investments.
Time until maturity: Investment prices usually increase or decrease to an amount close to par as the maturity date gets closer. Par is the amount you will be paid when the investment matures.
Demands for higher yields for long-dated investments: Investors demanding higher yields for long-dated investments can impact those investments’ yield curves. This is due to lower visibility of inflation, interest rates, and other price-sensitive factors.
The yield on longer-dated investments falling below shorter-dated investments: Known as an inverted yield curve, this event historically is a reliable indicator of a possible recession. This is due to the likelihood of interest rate reductions by central banks and investors trying to secure higher yields of long-term investments. This increases investment prices while depressing the yield.
What are the pros and cons of fixed-income investing?
As with all investment options, there are pros and cons to fixed-income investing. Let’s explore them.
Pros:
Diversification: You can diversify your portfolio beyond cash, property, shares, and other assets.
Lower-risk option: Fixed-income investments are a lower-risk option than equities, as the US and UK governments have never defaulted on these types of investments.
Predictable income stream: You can receive a predictable, stable income stream from these types of investments, unlike the fluctuating dividend payments from equities.
Cons:
Interest rate risk: Rising interest rates can reduce fixed-income investments’ market value.
Liquidity issues: Smaller potential buyer pools can make high-face-value investments issued by higher-risk or smaller companies less easily tradeable.
Risk of default: Fixed-income investing comes with ‘credit’ risk, which is the risk of governments or corporations defaulting on bonds.
What are some fixed-income investment strategies for different financial goals?
There are several different fixed-income investment strategies for different financial goals. A few of them include:
Laddering: This strategy sees you invest in a series of short-term bonds and then reinvest the returned principal into new short-term bonds for access to ready capital and rising market interest rates.
Bond funds: Also known as fixed-income mutual funds, bond funds offer exposure to different bonds and debt instruments, an income stream, and professional portfolio management.
Investing in inflation-protected securities: Being indexed to inflation means the principal and interest of these securities rise and fall with the inflation rate.
Can I invest in fixed-income through mutual funds or ETFs?
Yes, you can. You can access a diversified portfolio of bonds and other fixed-income investment instruments. This is thanks to the focus of many mutual funds and exchange-traded funds (ETFs) on fixed-income assets.
What role can fixed-income investments play in a diversified portfolio?
Fixed-income investments can play an important role in a diversified portfolio. They offer income and stability and can act as a counterbalance to stocks and other more volatile assets.
How does fixed-income investing differ from other investment types?
The main difference between fixed-income investing and equities (stocks) is that fixed-income investments provide a predictable income stream. Equities offer company ownership but no guaranteed income.
How can I build my fixed-income portfolio?
Now that you have a better idea of what fixed-income investing is, you can see how this can be a good option if you want a lower-risk option that provides a stable stream of income. It’s important to consider the various investment options, pros, cons, various strategies and how different factors can influence prices.
Let us match you with an SEC-regulated financial advisor whose expert financial advice can guide you through the various options, helping you to make the best decisions for your needs.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.