Guide to Fixed Income

What Is Fixed Income?

Fixed income broadly refers to those types of investment security that pay investors fixed interest or dividend payments until its maturity date. At maturity, investors are repaid the principal amount they had invested. Government and corporate bonds are the most common types of fixed-income products. Unlike equities that may pay no cash flows to investors, or variable-income securities, where can payments change based on some underlying measure—such as short-term interest rates—the payments of a fixed-income security are known in advance.

In addition to purchasing fixed income securities directly, there are several fixed-income exchange-traded funds (ETFs) and mutual funds available.

KEY TAKEAWAYS

• Fixed income is a class of assets and securities that pay out a set level of cash flows to investors, typically in the form of fixed interest or dividends.
• At maturity for many fixed income securities, investors are repaid the principal amount they had invested in addition to the interest they have received.
• Government and corporate bonds are the most common types of fixed-income products.
• In the event of a company’s bankruptcy, fixed-income investors are often paid before common stockholders.

Understanding Fixed Income

Companies and governments issue debt securities to raise money to fund day-to-day operations and finance large projects. For investors, fixed-income instruments pay a set interest rate return in exchange for investors lending their money. At the maturity date, investors are repaid the original amount they had invested—known as the principal.

For example, a company might issue a 5% bond with a $1,000 face or par value that matures in five years. The investor buys the bond for $1,000 and will not be paid back until the end of the five-years. Over the course of the five years, the company pays interest payments—called coupon payments—based on a rate of 5% per year. As a result, the investor is paid $50 per year for five years. At the end of the five-years, the investor is repaid the $1,000 invested initially on the maturity date. Investors may also find fixed-income investments that pay coupon payments monthly, quarterly, or semiannually.

Fixed-income securities are recommended for conservative investors seeking a diversified portfolio. The percentage of the portfolio dedicated to fixed income depends on the investor’s investment style. There is also an opportunity to diversify the portfolio with a mix of fixed-income products and stocks creating a portfolio that might have 50% in fixed income products and 50% in stocks.

Treasury bonds and bills, municipal bonds, corporate bonds, and certificates of deposit (CDs) are all examples of fixed-income products. Bonds trade over-the-counter (OTC) on the bond market and secondary market.

Special Considerations

Fixed income investing is a conservative strategy where returns are generated from low-risk securities that pay predictable interest. Since the risk is lower, the interest coupon payments are also, usually, lower as well. Building a fixed income portfolio may include investing in bonds, bond mutual funds, and certificates of deposit (CDs). One such strategy using fixed income products is called the laddering strategy.

A laddering strategy offers steady interest income through the investment in a series of short-term bonds. As bonds mature, the portfolio manager reinvests the returned principal into new short-term bonds extending the ladder. This method allows the investor to have access to ready capital and avoid losing out on rising market interest rates.

For example, a $60,000 investment could be divided into one-year, two-year, and three-year bonds. The investor divides the $60,000 principle into three equal portions, investing $20,000 into each of the three bonds. When the one-year bond matures, the $20,000 principal will be rolled into a bond maturing one year after the original three-year holding. When the second bond matures those funds roll into a bond that extends the ladder for another year. In this way, the investor has a steady return of interest income and can take advantage of any higher interest rates.

Types of Fixed Income Products

As stated earlier, the most common example of a fixed-income security is a government or corporate bond. The most common government securities are those issued by the U.S. government and are generally referred to as Treasury securities. However, many fixed income securities are offered from non U.S. governments and corporations as well.

Here are the most common types of fixed income products:

• Treasury bills (T-bills) are short-term fixed-income securities that mature within one year that do not pay coupon returns. Investors buy the bill at a price less than its face value and investors earn that difference at the maturity.²
• Treasury notes (T-notes) come in maturities between two and 10 years, pay a fixed interest rate, and are sold in multiples of $100. At the end of the maturity, investors are repaid the principal but earn semiannual interest payments until maturity.³
• The Treasury bond (T-bonds) are similar to the T-note except that it matures in 20 or 30 years. Treasury bonds can be purchased in multiples of $100.⁴
• Treasury Inflation-Protected Securities (TIPS) protects investors from inflation. The principal amount of a TIPS bond adjusts with inflation and deflation.⁵
• A municipal bond is similar to a Treasury since it is government-issued, except it is issued and backed by a state, municipality, or county, instead of the federal government, and is used to raise capital to finance local expenditures. Muni bonds can have tax-free benefits to investors as well.⁶
• Corporate bonds come in various types, and the price and interest rate offered largely depends on the company’s financial stability and its creditworthiness. Bonds with higher credit ratings typically pay lower coupon rates.
• Junk bonds—also called high-yield bonds—are corporate issues that pay a greater coupon due to the higher risk of default. Default is when a company fails to pay back the principal and interest on a bond or debt security.
• A certificate of deposit (CD) is a fixed income vehicle offered by financial institutions with maturities of less than five years. The rate is higher than a typical saving account, and CDs carry FDIC or National Credit Union Administration (NCUA) protection.^7 8
• Fixed-income mutual funds (bond funds)—such as those offered by Vanguard—invest in various bonds and debt instruments. These funds allow the investor to have an income stream with the professional management of the portfolio. However, they will pay a fee for the convenience.
• Asset-allocation or fixed income ETFs works much like a mutual fund. These funds target specific credit ratings, durations, or other factors. ETFs also carry a professional management expense.

Advantages of Fixed Income

Fixed income investments offer investors a steady stream of income over the life of the bond or debt instrument while simultaneously offering the issuer much-needed access to capital or money. Steady income lets investors plan for spending, a reason these are popular products in retirement portfolios.

The interest payments from fixed-income products can also help investors stabilize the risk-return in their investment portfolio—known as the market risk. For investors holding stocks, prices can fluctuate resulting in large gains or losses. The steady and stable interest payments from fixed-income products can partly offset losses from the decline in stock prices. As a result, these safe investments help to diversify the risk of an investment portfolio.

Also, fixed-income investments in the form of Treasury bonds (T-bonds) have the backing of the U.S. government.⁹ Fixed income CDs have Federal Deposit Insurance Corporation (FDIC) protection up to $250,000 per individual.⁷ Corporate bonds, while not insured are backed by the financial viability of the underlying company. Should a company declare bankruptcy or liquidation, bondholders have a higher claim on company assets than do common shareholders.¹

Although there are many benefits to fixed income products, as with all investments, there are several risks investors should be aware of before purchasing them.

Risks Associated with Fixed Income

Credit and Default Risk

As mentioned earlier, Treasurys and CDs have protection through the government and FDIC.^9 7 Corporate debt, while less secure still ranks higher for repayment than do shareholders. When choosing an investment take care to look at the credit rating of the bond and the underlying company. Bonds with ratings below BBB are of low quality and consider junk bonds.¹⁰

The credit risk linked to a corporation can have varying effects on the valuations of the fixed-income instrument leading up to its maturity. If a company is struggling, the prices of its bonds on the secondary market might decline in value. If an investor tries to sell a bond of a struggling company, the bond might sell for less than the face or par value. Also, the bond may become difficult for investors to sell in the open market at a fair price or at all because there’s no demand for it.

The prices of bonds can increase and decrease over the life of the bond. If the investor holds the bond until its maturity, the price movements are immaterial since the investor will be paid the face value of the bond upon maturity. However, if the bondholder sells the bond before its maturity through a broker or financial institution, the investor will receive the current market price at the time of the sale. The selling price could result in a gain or loss on the investment depending on the underlying corporation, the coupon interest rate, and the current market interest rate.

Interest Rate Risk

Fixed-income investors might face interest rate risk. This risk happens in an environment where market interest rates are rising, and the rate paid by the bond falls behind. In this case, the bond would lose value in the secondary bond market. Also, the investor’s capital is tied up in the investment, and they cannot put it to work earning higher income without taking an initial loss. For example, if an investor purchased a 2-year bond paying 2.5% per year and interest rates for 2-year bonds jumped to 5%, the investor is locked in at 2.5%. For better or worse, investors holding fixed-income products receive their fixed rate regardless of where interest rates move in the market.

Inflationary Risks

Inflationary risk is also a danger to fixed income investors. The pace at which prices rise in the economy is called inflation. If prices rise or inflation increases, it eats into the gains of fixed income securities. For example, if fixed-rate debt security pays a 2% return and inflation rises by 1.5%, the investor loses out, earning only a 0.5% return in real terms.

Pros & Cons

Pros

• Steady income stream
• More stable returns than stocks
• Higher claim to the assets in bankruptcies
• Government and FDIC backing on some

Cons

• Returns are lower than other investments
• Credit and default risk exposure
• Susceptible to interest rate risk
• Sensitive to Inflationary risk

Example of Fixed Income

To illustrate, let’s say PepsiCo (PEP) floats a fixed-income bond issue for a new bottling plant in Argentina. The issued 5% bond is available at face value of $1,000 each and is due to mature in five years. The company plans to use proceeds from the new plant to repay the debt.

You purchase 10 bonds costing a total of $10,000 and will receive $500 in interest payments each year for five years (0.05 x $10,000 = $500). The interest amount is fixed and gives you a steady income. The company receives the $10,000 and uses the funds to build the overseas plant. Upon maturity in five years, the company pays back the principal amount of $10,000 to the investor who earned a total of $2,500 in interest over the five years ($500 x five years).

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