Fixed-income securities are commonly used to diversify an investor's portfolio, as they reduce the overall risk of an asset allocation or investment strategy weighted heavily in the stock market. Fixed-income securities such as corporate bonds, government bonds, preferred company stocks and certificates of deposit (CDs) are more stable than pure equity holdings. Investors tend to rely on this asset class more during times of economic downturn or when steady income is the objective of the investment account.
Advantages to Investing in Fixed-Income Securities
Although fixed-income securities do not provide a great potential for upside return through capital appreciation or the opportunity to outpace inflation, income investing through fixed securities offers some unique advantages over growth investing using equities.
Stability of Principal
One advantage of investing in fixed-income securities is the peace of mind that comes from a stable portfolio balance and capital preservation. By definition, fixed-income securities are required to repay the original amount of the investment, known as the principal balance, in full at a specific date in the future or in increments spread out over the duration of the investment.
When fixed-income securities are highly-rated, as is the case with U.S. government bonds, there is minimal risk that the entity offering the fixed-income security will be unable to repay investors in full when the investment matures. Similarly, financial institutions that offer CDs are backed by deposit insurance agencies that safeguard customer deposits should a bank or credit union go bankrupt. This reduces or eliminates the concern investors have about portfolio fluctuations over time and the potential of not meeting the objective of the investment account due to market volatility.
Generates a Steady Income Stream
In addition to the benefit of capital appreciation, fixed-income securities provide investors with a steady stream of income generated from a portfolio's balance. Bonds, preferred stocks and CDs all pay steady dividend and interest payments to investors, creating a consistent cash inflow to investors. Fixed-interest and dividend rates are set when the security is issued, and these payments are guaranteed as long as the issuing entity does not default.
Federal government bonds are the least likely to default on interest and dividend payments, while corporate bonds with lower credit agency ratings bear more default risk for investors. This feature of fixed-income securities is particularly attractive to investors near or in retirement who are receiving little or no income from other sources.
Higher Priority Claim to Assets
Fixed-income investors also benefit from their position in the capital structure of an entity issuing both equity and debt investments. Investors in bonds of a corporation have a higher priority over common and preferred stockholders of the same corporation should the company declare bankruptcy or be liquidated.
Bondholders, then, are more likely to be repaid their principal investment when assets are distributed during a liquidation event.