February 22, 2024
Fixed Income

How does fixed-income investing work?

You don’t see TV channels devoted to fixed-income investing the way you do with stocks. There aren’t any “gurus” with pricey trading programs promising you eye-popping returns from fixed-income trades, and you won’t find many people at cocktail parties bragging about their latest bond investment.

But fixed-income investments still play a crucial part in an investor’s diversified portfolio.

What is fixed-income investing?

Fixed-income investing typically means investing in bonds, but fixed-income investments can also include preferred stocks and some annuities. These investments go by the name “fixed income” because they provide a fixed, predetermined return through interest payments.

These investments don’t have the razzle-dazzle factor of stocks, but bonds and other fixed-income securities play a valuable role in a portfolio.

They provide protection from the volatility of stocks and generate income regardless of how the stock market is performing.

Is fixed-income investing right for you?

There’s a widely held belief that fixed-income investing is only for retirees or investors with extremely low risk tolerance. While it’s true that fixed-income investments can help retirees preserve capital with lower risk than equities, in reality, a fixed-income allocation can help smooth portfolio returns even for younger investors and those who can take more risk.

“In truth, fixed-income investing is right for just about every investor,” says Sean Casterline, president and senior portfolio manager at Delta Capital Management in Maitland, Florida.

He says most of his older clients invest in Treasuries or investment-grade corporate bonds to generate yield.

“However, even younger investors can use hybrid fixed-income vehicles like convertible preferred stocks,” he says, adding that instruments such as convertible bonds can generate a handsome yield until converted to equity.

“So, even aggressive investors can use fixed-income in a way that adds some consistency and yield,” Casterline says.

But don’t forget that fixed-income investments are particularly suitable for retirees and older investors due to their inherent stability and reliable returns.

The pros and cons of fixed-income investing

Every investment has risks or potential drawbacks in addition to the possible reward.

Investing in fixed-income allocations adds stability and a regular return to a portfolio. Bonds are much less volatile than equities, so you won’t see some of the wild price fluctuations you see with growth equities.

Possible disadvantages include lower potential returns, susceptibility to inflation and interest-rate risk.

“The primary advantages of fixed-income investing include lower risk, predictable income, and capital preservation,” says Chad Willardson, president and founder of Pacific Capital, based in Corona, California. “These investments often provide steady cash flow through interest payments, which can be appealing for retirees or those seeking a regular income stream.”

Downsides include lower return potential compared to stocks; interest-rate risk, as bond prices typically fall when rates rise; and credit risk, particularly in lower-rated bonds. The reverse is also true, as bond prices rise when rates fall.

“Inflation can also erode the purchasing power of fixed-income returns over time,” he says.

The different types of fixed-income investments

When considering exactly what is fixed-income investing, bonds might be the first securities that come to mind.

Bonds represent a common asset class in an allocated portfolio. While other securities and products besides bonds also have a fixed rate of return, let’s first take a look at some different types of bonds. These can all be part of fixed-income investing strategies.

  • US government bonds: These are considered a low-risk, reliable investment. The tradeoff for that lower risk is typically a lower interest rate.
  • Treasury bills: Treasuries are U.S.-government debt securities with maturities of one year or less. That short term to maturity minimizes these bills’ risk.
  • Treasury notes: These are intermediate-term U.S. government debt securities whose maturities range from two to 10 years.
  • Treasury Inflation-Protected Securities: TIPS are Bonds that protect against inflation by indexing both principal and interest payments to consumer price changes.
  • Corporate bonds: The name is a giant clue as to what these are. These bonds are issued by companies, which don’t operate printing presses like governments do. That means investors take a higher risk with these bonds but also get a higher return.
  • Municipal bonds: These are bonds issued by local governments to fund public projects, like bridges or fire stations. These bonds are typically lower-risk than corporates and typically tax free.
  • High-yield bonds: You may have heard the term “junk bonds,” which is a more blunt description of high-yield instruments. High-yield bonds are issued by companies with a higher risk of default. To take this extra risk, investors demand a higher return.

Other types of fixed-income investments include certificates of deposit (CDs), which are savings accounts offered by banks that provide fixed interest rates over specified terms, such as three months, six months or a year.

Preferred stocks are another fixed-income investment that combines features of both stocks and bonds. They offer regular, fixed dividends like bonds but may also have the potential for capital appreciation.

Annuities, particularly fixed annuities, guarantee regular payments over a predetermined period. Many retirees like owning annuities because of the guaranteed income and because it’s a way to prevent overspending from other accounts.

Real estate investment trusts (REITs) may also be considered fixed-income securities, as they distribute fixed dividends that allow investors to benefit from real estate income without those pesky details of direct property ownership. Just keep in mind that REITs are subject to market swings and payouts can vary from distribution to distribution.

Potential risks associated with fixed-income investing

Investors may think of bonds and other fixed-income investments as being tame compared to stocks. Bonds are indeed less volatile, and some instruments, like CDs and annuities, offer a guaranteed return that’s not affected by market fluctuations.

But bonds do carry risk, chiefly surrounding credit quality and interest rates.

“Credit risk can be thought of as the risk that the issuer of the bond doesn’t pay, and defaults on their obligation,” says Christopher D. Robbins, investment advisor and principal at Bartlett Wealth Management in Cincinnati, Ohio.

If a company defaults on its payments, owners of the bond lose the income they were expecting to receive and usually some or all the value of the principal they expected to receive when the bond reached its maturity date, Robbins adds.

“The good news is this type of risk mainly comes into play when buying bonds of low-quality companies, which investors can avoid if they wish,” he says.

For investors who are comfortable taking on a higher level of credit risk to earn a higher return, this risk can be mitigated through portfolio diversification and by understanding exactly what they hold.

When it comes to interest-rate risk, plenty of investors saw this in 2022: As rates rose, bond prices fell. For example, the iShares Core US Aggregate Bond ETF (AGG), an investment-grade bond exchange-traded fund (ETF), declined by 13% that year as rates increased.

Having some interest-rate sensitivity in a bond portfolio over time isn’t necessarily a bad thing, Robbins says, but investors should be aware of what their bond holdings consist of. That’s not as easy, or as much fun, as tracking stock holdings, but it’s key to understanding what kind of return you’ll get.

“Bonds with shorter maturities have less interest rate sensitivity than longer maturity bonds,” he says. “Bond investors can favor short maturities to limit the interest rate sensitivity of their portfolios.”

Guidelines for fixed-income investing

When investing in fixed income, keep in mind a few easy-to-follow guidelines.

Fixed-income investments are a way to diversify a portfolio, but the days of a retiree owning only bonds are long gone. It’s necessary to hold at least a portion of retirement savings in stocks, which are more volatile but generate a higher return.

In general, it’s best to focus on high-quality bonds. Credit quality is determined by rating agencies such as Moody’s, Fitch or Standard & Poor. Those companies use a bond rating system to indicate how likely the issuer is to repay its debt.

Investment grade bonds are those whose issuer is deemed likely to repay its debt. Those are issued by big, well-established companies in good financial position. You may have heard the term “junk bonds,” which are also called high-yield bonds. Those represent the debt of companies whose finances are shaky, or of newer companies without a long track record of repaying debt.

As the name suggests, high-yield bonds typically pay more, but investors must be willing to take on the added risk.

Traditionally, investors were advised to subtract their age from 100 to get the percentage they should put in equities, with the remainder going into bonds. For example, using that calculation, an investor at age 35 would have 65% invested in stocks and 35% in bonds.

However, that’s not a one-size-fits-all formula. In many cases, even older investors, especially those who started late, simply need the extra profit they would generate through stocks.

This is where a financial plan, not a hunch or a broad “rule of thumb,” can help you figure out exactly how much income you’ll need, and what percentage of bonds versus stocks can help you get there.

Other fixed-income investing guidelines include diversifying your holdings, managing interest-rate and credit risk, and periodically reviewing and adjusting your fixed-income portfolio as the economic situation or your own personal situation changes.

Alternatives to investing in fixed-income

Investors seeking to generate income have several other choices in addition to the typical bonds or bond funds.

If investors want to keep their money liquid, says Casterline, they could consider sectors of the market that pay higher dividends.

“Traditionally, sectors like utilities, pharmaceuticals, energy and telecom pay high dividends that compare well to bond yields,” he says. “These sectors also tend to be less volatile than the overall market.”

He also says investors may want to also consider investing directly in real estate, rather than using publicly traded REITs.

“Buying rental houses or other forms of commercial real estate, such as multifamily or self-storage, can give investors good yields with the backing of real estate,” he says, adding that the downside is that brick-and-mortar real estate is not liquid. An investor who needs cash right away can’t just hit the “sell” button the way he or she could with a bond or bond fund.

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