Looking for a reliable and steady source of investment income? Maybe you’re getting closer to retirement and looking to take some risk out of your 401(k). Or maybe you have a low risk tolerance that means you shy away from equities in general. We’ve got you covered with our guide to fixed-income securities – what they are, what they can do for you and what risks they carry.
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Fixed-Income Securities: The Basics
A fixed-income security pays out a set amount over time. For example, a bond that pays a 2.5% interest rate is a fixed-income security. You don’t have to be on a fixed income to buy a fixed-income security. You should, however, be aware that your returns are by definition limited to the agreed-upon rate if you hold that security to maturity. There are securities that are not fixed-income, such as those that are inflation-indexed or equity-indexed. These pay a variable interest rate instead of a fixed one.
Probably the most famous type of fixed-income investment is the US Treasury Bond. These are considered a rock-solid place to park your money and are backed by the full faith and credit of the US government. But Treasury bonds aren’t the only bonds out there. There are also corporate bonds, tax-free municipal bonds and international bonds.
If you’re looking for a fixed-income security that isn’t a bond, consider mortgage- or other asset-backed securities. Another option is the money market fund. What these many investment vehicles have in common is that they will pay a fixed interest rate for a pre-set period of time. That makes them potentially lower-risk complements to equities.
You can judge a fixed-income security on its price, its yield or its coupon. The price is straightforward, and can fluctuate between the time a bond is issued and when it matures. The coupon is the amount you get in regular payments. The yield is the percent of the price that equals the coupon. So, if the price of your bond increases, the yield decreases.
When you buy a fixed-income security you pay its face value. You then receive regular interest payments and if you hold until maturity you get the face value (your principal) back. If your security increases in price you have to sell it to realize that gain.
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Risks of Fixed-Income Securities
Unlike with fixed-income securities, when you invest in stocks, you’re not guaranteed to get your initial investment back. That’s why fixed-income securities are considered to be lower-risk investments. They’re not, however, risk-free. When you hold fixed-income securities you’re vulnerable to several kinds of risk:
- Inflation Risk: Inflation is a risk because it eats into the real return from your security by diminishing the purchasing power of the dollars you’ve invested and dollars you receive in interest payments. That $50 a month doesn’t look as good when inflation kicks in. If you buy a fixed-income security that pays a percentage lower than the percentage of inflation, you’re losing money right out of the gate.
- Interest Rate Risk: Another risk to holding fixed-income securities is interest rate risk. Interest rates and bond prices have an inverse relationship. When interest rates rise, prices of existing bonds fall. If you hold your bond to maturity, you’re not affected by the drop in value of a bond you bought before interest rates rose. However, you are missing out on the opportunity to buy new bonds with a higher interest rate if your money is already tied up in securities you bought before interest rates moved.
- Price Risk: Fixed-income securities also come with price risk. Securities have a time stamp. If you buy a 10-year bond and wait 10 years, you’ll get what you paid for that security. But if you find yourself strapped for cash and need to sell that security to get some liquidity into your life, you’re vulnerable to price risk – the risk that the price will have fallen since you bought the security.
- Exchange Rate Risk: Anyone holding fixed-income securities from a foreign country is vulnerable to exchange rate risk. If you own a security that pays out in a foreign currency, when the value of that currency falls you get less money. On the other hand, if the value of that currency increases relative to the dollar, your security becomes more valuable.
- Credit Risk: Finally, some securities carry risk of default (also known as credit risk). The company or government that issues the security could find itself unable to pay what it owes you, leaving you high and dry. This is generally considered to be a negligible risk with US Treasury bonds and, to a lesser extent, with investment-grade bonds. Junk bonds, on the other hand, come with more credit risk.
Related Article: Getting Started with Retirement Planning
Fixed-income securities can offer you some transparency and peace of mind in the chaotic world of investing. The closer you are to retirement, the more drawn to fixed-income securities you may feel. It can be nice to have a predictable source of income, especially for your golden years.
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