Fixed Income

Offering steady income while minimizing risks

What Is Fixed Income?

Fixed income is a type of investment security that pays investors fixed interest 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. However, there are fixed income exchange-traded funds and mutual funds available.

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.

Fixed Income Explained

Companies and governments issue debt securities to raise money to fund day-to-day operations and finance large projects.

Fixed-income instruments pay investors 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. The company will pay interest for those five years called coupon payments. The amount will depend on the investment made for a particular period which here is five years. As a result, the investor is paid $50 per year for five years. At the end of the five years which is known as maturity; the investor is repaid $1,000 that was invested initially. Investors may also find fixed income investments that return coupon payments monthly, quarterly, or half-yearly.

Key Takeaways

Fixed income is a type of security that pays investors fixed interest 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.
In the event of a company’s bankruptcy, fixed-income investors are paid before common stockholders.

Types Of Fixed Income Products

1

Treasury bills (T-bill) are short-term fixed-income securities that mature within one year that do not pay coupon return. Investors buy the bill at a price less than its face value and investors earn that difference at the maturity.

2

The Treasury bond (T-bond) is very similar to the T-note except that it matures in 30 years. Treasury bonds can have face values of $10,000 each.

3

Treasury notes (T-note) come in maturities between two and 10 years, pay a fixed interest rate, and usually have a $1,000 face value. At the end of the maturity, investors are repaid the principal but earn semiannual payments of interest each year they hold the note.

4

Treasury Inflation-Protected Securities (TIPS) protect investors from inflation. The principal amount of a TIPS bond adjusts with inflation and deflation.

5

A municipal bond is similar to Treasury’s but is issued and backed by a state, municipality, or country, and finances capital expenditures. Municipal 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 depend on the company’s financial stability and its creditworthiness. Bonds with higher credit ratings typically pay lower coupon rates.

7

Junk bonds – also called high-yield bonds-are corporate issues that pay higher coupons 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.

8

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 savings account, and CDs carry FDIC or National Credit Union Administration (NCUA) protection.

9

Fixed-income mutual 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 professional portfolio management. However, they will pay a fee for the convenience.

10

Asset-allocation or fixed-income ETFs work much like a mutual fund. These funds target specific credit ratings, durations, or other factors. ETFs also carry a professional management expense.

Pros

Steady income stream
More stable returns than stocks
Higher claim to the assets in bankruptcies

Cons

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

Interest Rate Risk

Fixed-income investors face interest rate risk when market rates rise, making their bond’s fixed rate less competitive and lowering its value in the secondary market. Their capital remains tied up, preventing reinvestment at higher rates without a loss. For example, if an investor buys a 2-year bond at 2.5% and rates rise to 5%, they are locked in at the lower rate. Regardless of market changes, fixed-income investors receive the fixed rate.