If you’re an investor who values protecting the money you have while making a little return versus growing your nest egg, fixed income is right for you. If you are looking for a little diversification and something to mitigate the price swings in your equity portfolio, fixed income can be a good option as well. The best fixed-income investments are the ones that meet your goals.
With interest rates hovering around 5%, fixed-income markets, also known as bond and debt markets, offer investors return with less risk than investing in stocks. It’s a big market, too, with many different ways to invest. “Even though equity gets a lot more print, fixed income is a much larger asset class,” said Jonathan Lee, senior portfolio manager at US Bank Private Wealth Management.
What is fixed income?
As the name implies, fixed-income investment pays a fixed amount of money to an investor, usually at regular intervals for a predefined time. An entity, whether it’s a government or a business, issues a bond when it seeks to raise money. An investor buys the bond, which is a loan to the entity for a set amount of money, for a set amount of time.
When bonds are issued, they include a maturity date, which is the life of the bond. That can be as short as a month, or it can be for 30 years or sometimes longer. They also have a yield, which is how much money the entity pays the investor for making the loan. This is often expressed in percentages, such as a 5% yield. For example, a $1,000 bond with a 5% annual yield pays the bondholder $50 yearly. If everything goes smoothly, bonds provide “some security of income for the investor,” Lee said.
Fixed income versus equities
With bonds, you are looking for a less-risky, less-volatile investment that provides a regular income stream. Bonds generally are for conservative investors.
With equities, you are looking for growth, Lee said. Stocks offer more capital appreciation but also come with higher risk for capital depreciation when stock prices drop. Stocks and bonds can be a good offset for each other, however, because stocks offer greater growth over the long run while bonds offer a stabilizing ballast to provide a return when stocks fall.
Risks and rewards
Bond rewards are well known, as they provide a consistent income stream. But they’re not fail-safe. Fixed income has a few main risks, including inflation risk, interest-rate risk, credit risk and default risk.
Inflation risk
Inflation risk occurs when prices rise but the income you are paid stays constant, meaning your purchasing power falls. As an example, the $50 you receive on a $1,000 bond with a 5% yield doesn’t buy as much as it did five years ago.
Interest-rate risk
Interest-rate risk occurs when current yields rise higher than the yield on the bond you own. For example, if you own a bond that yields 2% and the current market yield is 5%, your bond is worth less.
A bond’s face value is made up of two components: the yield and the price. Those values are fixed. If a bond trades on the secondary market, the yield and the price will move inversely to keep the value the same. For example, when a bond is issued, it may have a 5% yield and a price of $100. If the price rises to $101, the yield will fall incrementally to keep the face value the same. The yield will rise slightly if the price falls.
However, interest-rate risk is only a factor if you want to sell your bond. If you hold it to maturity, you will receive all of your interest payments, also known as coupon payments, plus your principal.
Credit risk
Credit risk is determined by an issuer’s ability to repay the bond, Lee said. The three credit-rating agencies, Standard & Poor’s, Moody’s and Fitch, assign letter-grade ratings for an entity’s creditworthiness. At the high end is what’s called investment-grade credit. These are considered safer bond investments.
At the lower end of the credit-quality range is what’s called noninvestment grade, or speculative, credit. The ratings begin at BB and continue down to C for Moody’s and D for S&P and Fitch. These are the weakest ratings.
The lower the credit quality, the higher the yield, Lee said. Credit risk is key for municipal, corporate and high-yield bonds in particular.
“When we’re taking more credit risk, we need to be compensated for it,” Lee said.
Default risk
Default risk is the most serious risk for bond investments, as it means the issuer is no longer able to make the interest payments. Craig Elder, senior fixed-income analyst at Robert W. Baird, said defaults can cause bond investors to lose their income stream and, in some cases, their principal as well.
Seven fixed-income investment ideas
1. Treasuries
The United States government issues Treasury notes, bonds and bills. These are seen to be risk-free, said Lee and Elder, as they are backed by the full faith and credit of the US, so they aren’t expected to ever default. Because of their perceived safety, Treasuries often have lower yields than other fixed-income securities.
2. Treasury Inflation Protected Securities
Treasury Inflation Protected Securities (TIPS) help to protect buyers from inflation risk and are sold for terms of five, 10 or 30 years. The face value of TIPS rise with inflation and fall with deflation, as measured by the consumer price index (CPI). When TIPS mature, owners receive either the inflation-adjusted price or the original principal paid. Interest is paid every six months until maturity. Both TIPS and Treasuries are sold by the US government via its TreasuryDirect website.
3. Municipal bonds
Municipal bonds are issued by state and local governments. Buyers seek out these bonds because they are often free from federal tax and may also be shielded from state taxes. Credit rating agencies will issue ratings on muni bonds, depending on the economic strength of the municipality. Lee said these are considered lower-risk bonds because municipalities can raise taxes if they need to repay bonds. Yields on these bonds appear lower than other bonds, but their tax-equivalent yields are higher once a buyer factors in their tax rate.
4. High-yield (junk) bonds
Junk bonds are issued by companies that have below-investment-grade debt. The yields are higher because there’s a chance of default, so buyers demand to receive more money for the risk they are taking. Most high-yield bonds have very short maturities, only a few years or less, which can reduce the odds that the company will default.
5. Bond funds
Bond funds are a way for investors to buy hundreds or thousands of bonds in one transaction and can be a viable alternative to buying a single bond. Available as mutual funds or exchange-traded funds (ETFs), bond funds can reduce single-bond risk and offer diversification. Investors interested in bond funds should look at the fund’s yield and duration, which is how sensitive a bond is to changes in interest rates, and make sure the fund’s objectives match with their investment goals.
6. Corporate bonds
Corporate bonds are issued by companies looking to raise funds. Lee said investment-grade corporate bonds will have higher yields than Treasury and municipal bonds because there is higher credit risk. “Corporations do not have the taxing authority that a municipality would. They can’t print money like the United States can, so there’s going to be more risk there,” he said. Look for bonds rated BBB- or higher to get investment-grade quality bonds. Elder said corporate bonds sometimes get downgraded, and those whose ratings fall from investment grade to high yield are called “fallen angels” because of declining financial conditions at the company.
7. Certificates of deposit
Certificates of deposit (CDs) are fixed-income vehicles often offered by banks. They are issued with terms from a few months to several years, during which time CD buyers lock up their money in exchange for a fixed interest rate. When the term ends, they receive their principal and interest. Banks may penalize buyers who want to cash in their money early, so read the fine print before buying. Elder said the yields on CDs are similar to Treasury yields, and up to $250,000 invested in a CD through a federally insured bank is protected by the Federal Deposit Insurance Corp. (FDIC).
Four alternatives to fixed-income investing
Investors seeking income can look outside of the fixed-income market, especially if they want higher yields. However, they should be aware that these alternatives are proxies for bonds and don’t have the same level of safety.
1. Preferred stock
A hybrid between stocks and bonds, preferred stock is considered less risky than common stock but riskier than bonds. Preferred stockholders have priority over common stockholders regarding dividend payouts, and they may get some capital appreciation if stock prices rise. If a company fails, preferred shareholders also get priority in any distributions over common shareholders. However, preferred shareholders have no voting rights.
2. Dividend stocks
Elder said some investors seek out stocks that pay high dividends as another way to get income. This can be a popular alternative when interest rates are low.
3. Real estate investment trusts
Real estate investment trusts (REITs) are an alternative investment that focus on real estate across a variety of property sectors. These companies own or finance properties that produce income and must pay out a certain amount of income generated, Lee said.
4. Master limited partnerships
Master limited partnerships (MLPs) generally operate energy infrastructure, usually pipelines, and often pay high yields. MLP buyers should be aware that some of these investment vehicles have special tax treatment and are required to issue certain, sometimes complicated annual tax forms to investors.
Is fixed income the right investment strategy for you?
Like any investment, fixed income should be considered as part of your wider investment goals. Usually, people near retirement who are looking to preserve their principal will own more bonds than stocks; however, Elder said younger investors with longer investment horizons may benefit from a smaller amount of bonds to help diversify their portfolios.
