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.
A financial advisor can help you determine how to add fixed-income securities to your investment portfolio.
Fixed-Income Securities 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.
Fixed-Income Investments
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.
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.
Diversification Strategies for Fixed-Income Investments
Diversification is a key strategy for managing the risks and enhancing the returns of fixed-income investments. By spreading investments across various types of fixed-income securities, such as government bonds, corporate bonds, and municipal bonds, investors can mitigate the impact of any single security’s performance on their overall portfolio. This approach also allows investors to benefit from different interest rates, credit qualities and maturity dates, which can help stabilize returns over time.
Adding international bonds to a fixed-income portfolio is another effective diversification strategy. This exposes investors to global economic conditions, which could potentially offer higher yields than domestic bonds. However, you should also note that there are added risks from exchange rate fluctuations and economic instability in foreign markets. Investors can balance these risks by selecting a mix of securities from both developed and emerging markets, and adjusting the allocation based on risk tolerance and investment goals.
Asset-backed securities like mortgage-backed securities (MBS) or collateralized debt obligations (CDOs) can also diversify your fixed-income portfolio. These securities are backed by real assets, such as mortgages or loans, providing another layer of security and a different risk-return profile when compared with traditional bonds. Diversifying with these instruments can offer additional yield opportunities while spreading risk across various sectors and types of issuers.
Fixed-Income Securities vs. Other Investments
First, you should consider the lower risk and predictable returns that bounds could offer. If you value stability and regular income, these fixed-income securities might be the right choice for you. They provide scheduled interest payments and return the principal at maturity, which can be more reassuring than the volatile returns of stocks or the hands-on management required by real estate.
However, if you’re looking for potential growth or higher returns, stocks might be more appealing than fixed-income securities. While stocks come with higher volatility, they also offer the possibility of substantial capital gains, especially in a growing economy. However, you should be prepared for the ups and downs of the market, which can significantly affect your investment’s value over the short term.
Real estate investments are another common alternative to fixed-income securities because they offer tangible assets and can provide rental income along with potential property value increases. These assets, however, require more active management and involve higher upfront costs when compared with buying bonds. If you’re comfortable dealing with tenants, maintenance and the fluctuating real estate market, this might be a lucrative option for you. But, if you prefer a more hands-off investment, fixed-income securities are likely a better fit.
Tax Implications for Fixed-Income Investments
The interest you earn from fixed-income securities like bonds is typically subject to federal income tax. And, depending on the bond type, state and local taxes as well. However, municipal bonds can be an attractive option because they often provide tax-exempt income, meaning you don’t have to pay federal taxes, and in some cases, state and local taxes either, depending on where you live.
If you’re in a higher tax bracket, tax-exempt bonds might be particularly beneficial for you. By investing in these, you can lower your taxable income while still receiving steady returns. It’s important to compare the after-tax return of tax-exempt bonds with taxable bonds to see which option gives you the better net benefit for your current tax situation.
Remember, if you sell a bond for more than you paid (at a capital gain), those earnings are also subject to taxes, typically at the capital gains rate if held for over a year. Planning your investments according to these tax rules can help you maximize returns and minimize the tax hit. Always consider consulting with a tax professional to make the most informed decisions based on your specific financial circumstances.
Bottom Line
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. But you should note that while these assets could provide predictable income, they can also offer lower returns when compared with other more volatile investments.
Investment Planning Tips
- A financial advisor can help you analyze investments and manage risk for your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to diversify your portfolio, here’s a roundup of 13 investments to consider.
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