What Is a Fixed-Income Security?
A fixed-income security is an investment that provides a return in the form of fixed periodic interest payments and the eventual return of principal at maturity. Unlike variable-income securities, where payments change based on some underlying measure—such as short-term interest rates—the payments of a fixed-income security are known in advance.
- Fixed-Income security provides investors with a stream of fixed periodic interest payments and the eventual return of principal upon its maturity.
- Bonds are the most common type of fixed-income security, but others include CDs, money markets, and preferred shares.
- Not all bonds are created equal. In other words, different bonds have different terms as well as credit ratings assigned to them based on the financial viability of the issuer.
- The U.S. Treasury guarantees government fixed-income securities, making these very low risk, but also relatively low-return investments.
Fixed-Income Securities Explained
Fixed-Income securities are debt instruments that pay a fixed amount of interest—in the form of coupon payments—to investors. The interest payments are typically made semiannually while the principal invested returns to the investor at maturity. Bonds are the most common form of fixed-income securities. Companies raise capital by issuing fixed-income products to investors.
A bond is an investment product that is issued by corporations and governments to raise funds to finance projects and fund operations. Bonds are mostly comprised of corporate bonds and government bonds and can have various maturities and face value amounts. The face value is the amount the investor will receive when the bond matures. Corporate and government bonds trade on major exchanges and usually are listed with $1,000 face values, also known as the par value.
Credit Rating Fixed Income Securities
Not all bonds are created equal meaning they have different credit ratings assigned to them based on the financial viability of the issuer. Credit ratings are part of a grading system performed by credit-rating agencies. These agencies measure the creditworthiness of corporate and government bonds and the entities ability to repay these loans. Credit ratings are helpful to investors since they indicate the risks involved in investing.
Bonds can either be investment grade on non-investment grade bonds. Investment grade bonds are issued by stable companies with a low risk of default and, therefore, have lower interest rates than non-investment grade bonds. Non-investment grade bonds, also known as junk bonds or high-yield bonds, have very low credit ratings due to a high probability of the corporate issuer defaulting on its interest payments.
As a result, investors typically require a higher rate of interest from junk bonds to compensate them for taking on the higher risk posed by these debt securities.
Types of Fixed-Income Securities
Although there are many types of fixed-income securities, below we've outlined a few of the most popular in addition to corporate bonds.
Treasury notes (T-notes) are issued by the U.S. Treasury and are intermediate-term bonds that mature in two, three, five, or 10 years. T-Notes usually have a face value of $1,000 and pay semiannual interest payments at fixed coupon rates or interest rates. The interest payment and principal repayment of all Treasurys are backed by the full faith and credit of the U.S. government, which issues these bonds to fund its debts.
Another type of fixed-income security from the U.S. Treasury is the Treasury bond (T-bond) which matures in 30 years. Treasury bonds typically have par values of $10,000 and are sold on auction on TreasuryDirect.
Short-term fixed-income securities include Treasury bills. The T-bill matures within one year from issuance and doesn't pay interest. Instead, investors can buy the security at a lower price than its face value, or a discount. When the bill matures, investors are paid the face value amount. The interest earned or return on the investment is the difference between the purchase price and the face value amount of the bill.
A municipal bond is a government bond issued by states, cities, and counties to fund capital projects, such as building roads, schools, and hospitals. The interest earned from these bonds is tax exempt from federal income tax. Also, the interest earned on a "muni" bond might be exempt from state and local taxes if the investor resides in the state where the bond is issued. The muni bond has several maturity dates in which a portion of the principal comes due on a separate date until the entire principal is repaid. Munis are usually sold with a $5,000 face value.
A bank issues a certificate of deposit (CD). In return for depositing money with the bank for a predetermined period, the bank pays interest to the account holder. CDs have maturities of less than five years and typically pay lower rates than bonds, but higher rates than traditional savings accounts. A CD has Federal Deposit Insurance Corporation (FDIC) insurance up to $250,000 per account holder.
Companies issue preferred stocks that provide investors with a fixed dividend, set as a dollar amount or percentage of share value on a predetermined schedule. Interest rates and inflation influence the price of preferred shares, and these shares have higher yields than most bonds due to their longer duration.
Benefits of Fixed-Income Securities
Fixed-income securities provide steady interest income to investors throughout the life of the bond. Fixed-income securities can also reduce the overall risk in an investment portfolio and protect against volatility or wild fluctuations in the market. Equities are traditionally more volatile than bonds meaning their price movements can lead to bigger capital gains but also larger losses. As a result, many investors allocate a portion of their portfolios to bonds to reduce the risk of volatility that comes from stocks.
It's important to note that the prices of bonds and fixed income securities can increase and decrease as well. Although the interest payments of fixed-income securities are steady, their prices are not guaranteed to remain stable throughout the life of the bonds.
For example, if investors sell their securities before maturity, there could be gains or losses due to the difference between the purchase price and sale price. Investors receive the face value of the bond if it's held to maturity, but if it's sold beforehand, the selling price will likely be different from the face value.
However, fixed income securities typically offer more stability of principal than other investments. Corporate bonds are more likely than other corporate investments to be repaid if a company declares bankruptcy. For example, if a company is facing bankruptcy and must liquidate its assets, bondholders will be repaid before common stockholders.
The U.S. Treasury guarantees government fixed-income securities and considered safe-haven investments in times of economic uncertainty. On the other hand, corporate bonds are backed by the financial viability of the company. In short, corporate bonds have a higher risk of default than government bonds. Default is the failure of a debt issuer to make good on their interest payments and principal payments to investors or bondholders.
Fixed-income securities are easily traded through a broker and are also available in mutual funds and exchange-traded funds. Mutual funds and ETFs contain a blend of many securities in their funds so that investors can buy into many types of bonds or equities.
Fixed-income securities provide steady interest income to investors throughout the life of the bond
Fixed-income securities are rated by credit rating agencies allowing investors to choose bonds from financially-stable issuers
Although stock prices can fluctuate wildly over time, fixed-income securities usually have less price volatility risk
Fixed-income securities such as U.S. Treasuries are guaranteed by the government providing a safe return for investors
Fixed-income securities have credit risk meaning the issuer can default on making the interest payments or paying back the principal
Fixed-income securities typically pay a lower rate of return than other investments such as equities
Inflation risk can be an issue if prices rise by a faster rate than the interest rate on the fixed-income security
If interest rates rise at a faster rate than the rate on a fixed-income security, investors lose out by holding the lower yielding security
Risks of Fixed-Income Securities
Although there are many benefits to fixed-income securities and are often considered safe and stable investments, there are some risks associated with them. Investors must weigh the pros and cons of before investing in fixed-income securities.
Investing in fixed-income securities usually results in low returns and slow capital appreciation or price increases. The principal amount invested can be tied up for a long time, particularly in the case of long-term bonds with maturities greater than 10 years. As a result, investors don't have access to the cash and may take a loss if they need the money and cash in their bonds early. Also, since fixed-income products can often pay a lower return than equities, there's the opportunity of lost income.
Fixed-income securities have interest rate risk meaning the rate paid by the security could be lower than interest rates in the overall market. For example, an investor that purchased a bond paying 2% per year might lose out if interest rates rise over the years to 4%. Fixed-income securities provide a fixed interest payment regardless of where interest rates move during the life of the bond. If rates rise, existing bondholders might lose out on the higher rates.
Bonds issued by a high-risk company may not be repaid, resulting in loss of principal and interest. All bonds have credit risk or default risk associated with them since the securities are tied to the issuer's financial viability. If the company or government struggles financially, investors are at risk of default on the security. Investing in international bonds can increase the risk of default if the country is economically or politically unstable.
Inflation erodes the return on fixed-rate bonds. Inflation is an overall measure of rising prices in the economy. Since the interest rate paid on most bonds is fixed for the life of the bond, inflation risk can be an issue if prices rise by a faster rate than the interest rate on the bond. If a bond pays 2% and inflation is rising by 4%, the bondholder is losing money when factoring in the rise in prices of goods in the economy. Ideally, investors want fixed-income security that pays a high enough interest rate that the return beats out inflation.
Real World Examples of Fixed-Income Securities
As mentioned earlier, Treasury bonds are long-term bonds with a maturity of 30 years. T-Bonds provide semiannual interest payments and usually have $1,000 face values. The 30-year Treasury bond that was issued March 15, 2019, paid a rate of 3.00%. In other words, investors would be paid 3.00% or $30 on their $1,000 investment each year. The $1,000 principal would be paid back in 30 years.
On the other hand, the 10-year Treasury note that was issued March 15, 2019, paid a rate of 2.625%. The bond also pays semiannual interest payments at fixed coupon rates and usually has a $1,000 face value. Each bond would pay $26.25 per year until maturity.
We can see that the shorter-term term bond pays a lower rate than the long-term bond because investors demand a higher rate if their money is going to be tied up longer in longer-term fixed-income security.