Make the most of a high-interest-rate environment with these fixed-rate investments.
As the Federal Reserve has raised interest rates to cool inflation over the past year or so, fixed-income investments have become an increasingly attractive investment vehicle for some. That’s because fixed-income investments are typically less volatile and risky than equities, and many investors also use these investments to diversify their portfolios.
Daniel Bergstresser, associate professor of finance at Brandeis International Business School, points out that the “amount of diversification from fixed-income investments seems to vary over time. During the ’60s and ’70s, stock and bond prices were highly correlated. They weren’t very correlated in the 2000s, and correlation zoomed back up in 2022.”
The takeaway for investors is that fixed-income investments are still a great way to take advantage of a high-interest-rate environment, even if they don’t provide as much portfolio diversification at the moment. Ultimately, each investor’s situation is unique, and different fixed-income investments may be more or less suitable for different people.
What Is Fixed Income?
Fixed-income investments generally pay a fixed interest rate or dividend until maturity.
Some of the language surrounding fixed-income investments can be confusing, so here are some basic terms to know:
- Price: the current value of your investment. Bond prices have an inverse relationship with bond yields.
- Maturity: the day your investment expires and – for some investments – when the principal is repaid to you.
- Coupon: the fixed rate of interest that you receive.
- Yield: Not to be mistaken with the coupon payment, the yield is the overall return from the fixed-income investment that you receive. Broadly, it is inclusive of both the effects of coupon payments and also any changes in the face value of the bond itself.
Certificates of Deposit
Certificates of deposit, or CDs, are short-term savings vehicles offered by banks that often pay higher interest rates than savings accounts. However, CDs are illiquid and cannot be withdrawn without significant penalties. Some one-year CDs pay annual percentage yields, or APYs, of more than 5% as of June 23, which reflects the relatively high short-term rate environment. As a result, a short-term CD could be a great way to lock in a solid interest rate for a short period.
Taxes: income tax rate
Money Market Funds
Money market funds are a subclass of mutual funds that are designed to invest in highly liquid, fixed-income assets. They generally have higher yields than savings accounts and are more liquid than CDs. However, they are not insured by the Federal Deposit Insurance Corporation, or FDIC. Because money market funds are mutual funds that are managed, they may have high expense ratios that reduce their overall yield. As a result, a money market fund might make sense for someone who wants to save a small amount of cash and receive a decent yield.
Taxes: income tax rate
Bond ETFs and Mutual Funds
Bond investing can be complicated, as investors must consider their liquidity needs and tax situations. Furthermore, purchasing individual bonds can require investors to pay premiums, whereas portfolio managers of bond exchange-traded funds, or ETFs, and mutual funds can obtain a bulk order of bonds for a discount. As a result, bond ETFs and mutual funds may make sense for investors who are willing to sacrifice some customization of their portfolios for reliable liquidity and cash flow.
Taxes: variable
Short-Term Bonds
Short-term bonds are corporate or government bonds that have a shorter time to maturity. While this generally reduces the chance of being locked into an unfavorable interest rate over a long period, short-term bonds generally have lower yields. This is not always true, however; when there’s an inverted yield curve (as there is in June 2023), short-term rates can actually boast higher yields than bonds with a longer maturity.
Taxes: income tax rate for interest and short-term capital gains for instruments held for a year or less
Corporate Bonds
Corporate bonds are bonds that are issued by companies. These bonds usually have higher yields than U.S. government bonds due to their higher risk. It’s important to check corporate bond ratings to determine whether they fit your risk profile. Bonds rated BBB- to AAA by Standard and Poor’s or Baa3 to Aaa by Moody’s indicate investment-grade bonds, which are less risky than lower-rated bonds.
Taxes: income tax rate for interest, capital gains tax depending on holding period
High-Yield Bonds
Also known as “junk” bonds, high-yield bonds are corporate bonds with low credit ratings – often rated below BBB- by S&P. In return for their greater risk of default, these bonds come with higher payouts than investment-grade bonds.
Anthony Lunger, managing director at Wilmington Trust, compares the risk-reward scenario for junk bonds to playing the stock market: “We have previously seen high-yield bonds paying about 8% – the same expected return from large-cap domestic stocks.”
Taxes: income tax rate for interest, capital gains tax depending on holding period
Municipal Bonds
Municipal bonds, also known as “munis,” are issued by government entities such as counties, cities and states. Munis are generally divided into two categories:
- General obligation munis are backed by the issuer, which can tax its residents to pay bondholders.
- Revenue bond munis are backed by revenues from a project that the muni is paying for, like the building of a leasable location or highway. Notably, if the project stops generating revenue, some revenue bond munis that are classified as “non-recourse” may not give investors access to funds from the project.
The strength of munis is that their interest payments are often exempt from federal income tax. And depending on the issuer of the muni, if you reside in the bounds of the issuing location, the interest may even be exempt from state and local taxes. Because of these tax benefits, the interest on munis is generally lower and as such you should consider your tax situation to determine whether it is worth it.
Taxes: variable, federal income tax exempt
I Bonds
I bonds are issued by the U.S. Treasury and have both a fixed interest rate component and a variable interest rate component, the latter of which is adjusted on a semiannual basis to reflect inflation levels. During deflationary periods, I-bonds will simply stop at a 0% interest rate so that investors do not receive negative rates during deflation.
I bonds fully mature after 30 years but can be cashed in as soon as one year. Cashing in an I bond within five years of its issue requires forfeiture of the last three months of interest payments. Another limitation is that investors can only buy up to $10,000 worth of I bonds per Social Security number annually. Furthermore, I bonds do not pay coupons. Instead, the coupons are immediately reinvested into the principal.
Taxes: interest taxed at federal level but not state/local levels
U.S. Treasurys
U.S. Treasurys are likely the world’s most famous fixed-income investments and are in many ways the backbone of the financial world, representing the return on a safe investment backed by the U.S. government. They include Treasury bonds, Treasury notes and Treasury bills.
Treasury bonds are long-term investments that mature in 20 or 30 years. Treasury notes mature in two to 10 years. Treasury bills mature within one year and as soon as four weeks. Because of their short holding periods, Treasury bills pay interest as a lump sum at maturity.
Because of the currently inverted yield curve, shorter-term Treasurys are paying higher yields, with the one-year Treasury currently paying more than 5%.
Taxes: federal tax on interest, no state or local taxes
Preferred Stock
While technically an equity investment, preferred stock holds characteristics that are similar to fixed-income investments. Preferred stock pays dividends, which remain consistent even when interest rates fall. It often carries higher yields than bonds and a substantial amount of the dividends from preferred stock have a favorable tax treatment because they are classified as qualified dividends.
Preferred stock is subordinate to debt even though it is senior to common stock, meaning that if a company goes bankrupt, preferred stockholders will be paid before common stockholders but after bond investors.
Taxes: qualified dividend tax rate, which is based on income and between zero and 20%
Treasury Inflation-Protected Securities
Treasury inflation-protected securities, or TIPS, are often confused with I bonds. Put simply, the difference between the two is that I bonds change their interest rates to adjust for inflation and TIPS change their principal values to adjust for inflation.
The main advantage of TIPS compared to I bonds is that there is no limit to how many TIPS you can buy. Furthermore, TIPS can be traded on secondary markets, which makes them more liquid.
The main disadvantage of TIPS compared to I bonds is that they have less favorable tax treatment and are federally taxed on both their interest payments and their principal when they are adjusted for inflation. Furthermore, TIPS can reduce in value – although if the principal value goes down when an investor sells TIPS, they will receive their initial investment value – and can have volatile valuations as they are tradable on secondary markets.
TIPS are sold for a minimum $100 investment and can be bought at holding periods of five, 10 or 30 years.
Taxes: interest and principal are both taxed at federal level but not at state and local level
Floating-Rate Notes
Floating-rate notes, or FRNs, are issued by financial firms, governments and corporations. They have variable coupon rates tied to a benchmark rate and mature in two to five years. Many pay interest four times a year and have a minimum $100 buy-in. One example is FRNs issued by the Treasury, which pays interest benchmarked to the 13-week Treasury bill added to an interest rate spread that is specified at the time of the FRN purchase.
Taxes: federal tax on interest, no state or local taxes
Bottom Line
With so many fixed-income options, deciding which type of investment is right for you can be daunting. If you’ve considered all of the above and still aren’t convinced, a popular alternative is a high-yield savings account. This type of account is easy to set up and maintains liquidity.
As a bonus, these accounts are insured up to $250,000 by the FDIC and can be a great way to earn money safely. With the current interest-rate environment, many high-yield savings accounts pay well above 4% APY.
