What is Fixed Income
Fixed income is a type of investment whose return is usually fixed or predictable and is paid at a regular frequency like annually, semi-annually, quarterly or monthly. Along with equities, fixed income forms an important part of the investment market and is used for raising capital by the companies and governments. Compared to the uncertain returns from equities, commodities and other investment classes, the predictable and regular returns from fixed-income investments can be used to efficiently diversify one's portfolio.
BREAKING DOWN Fixed Income
Equities are represented by shares, which denote the ownership in the company. The investors who purchase shares at a particular price do so in expectations of selling them later at a higher price and make profits. Since the share price movements are uncertain, equity returns are uncertain and considered a risky investment. While the company raises capital by issuing shares to common investors, it does not have any liability to refund that money, it is not obligated to make any regular payment to investors (like a dividend), and is not responsible for any adverse changes in share price.
Debt does not represent an ownership in the company, but acts as a loan. To raise capital, companies, government or other competent authorities may issue debt instruments that are interest-paying fixed income securities. Such instruments are issued for a specific period, during which the issuing entity pays an interest to the investors based on the specified terms. Investors purchasing these fixed income securities actually lend their money to the firms/authorities for the specified period to earn income in the form of interest. As a result, such fixed income investors are considered as creditors and often have a priority claim on company's asset compared to the equity shareholders in case of the company going bankrupt. The regular interest payments, better guarantee of returns, and priority claim in case of default – makes the fixed income investment less risky than equity. By issuing such instruments, government or companies use the capital collected for various purposes - like financing projects, building infrastructure or business expansion, the investors benefit by earning interest.
Different Types of Fixed Income Products
The most common example of a security that yields a fixed income is a bond. Bonds can be issued by federal governments, local municipalities or major corporations. They are issued for a specific period of time which can range from a few months to a few decades. Investors can invest in these instruments and are paid the specified interest for the period they remain invested.
U.S. Treasuries, the American government cabinet-level department, is responsible for issuing all kinds of government fixed income securities. The fixed income instruments issued by the U.S. Treasury pay a fixed income to the investors, and include Treasury bills (T-bills), Treasury notes (T-notes), and Treasury bonds (T-bonds). Treasury bills generally have maturity period of a year or less, treasury notes have maturity period from two to ten years, while treasury bonds have maturity of 30 years from their issue date. Government of a particular country can also issue sovereign bonds in foreign currencies which allows foreign investors to invest in their local currency. Governments can also issue special types of fixed income instruments – like a treasury security called Treasury Inflation-Protected Securities (TIPS) that provides protection to investors from the negative effects of inflation. The principal amount of a TIPS instrument increases with inflation and decreases with deflation, as measured by the Consumer Price Index.
A municipal bond is a similar fixed income security that is issued by a state, municipality or county to finance its capital expenditures.
Companies also issue bonds for raising capital which are called corporate bonds. Corporate issued bonds come in a variety of flavors, and depending upon the company’s business outlook, financial stability, credit rating and the working structure of the bond, such fixed income instruments are classified as guaranteed bonds, income bonds, investment-grade bonds and junk bonds.
The interest earned on the above mentioned fixed income instrument types varies based on their risk factor. Since government has the liberty to print money as required, the securities issued by the US treasury are considered risk-free and pay the least amount of interest. Municipal bonds comes with a slightly higher risk, and they pay comparatively higher interest, while the corporate bonds may pay much higher interest as they make the business related investments that are considered the riskiest among the lot. In general, bonds and fixed-income securities with longer-dated maturities pay a higher rate, because they are considered riskier. The longer the security is on the market, the more time it has to lose its value and/or default.
Important Terms Related to Fixed Income
- Issuer/Borrower: The issuer is the entity (government, authority, or company) which borrows the funds by issuing the fixed income security. The issuer is also responsible to pay interest at the specified intervals and repay the capital amount to the investors upon maturity of the security.
- Principal: Principal is the amount that an investor receives on maturity, and is also known as the maturity value, face value or par value.
- Coupon: The coupon refers to the annual interest linked with the fixed income security that the issuer must pay to the lender. It is usually expressed as a percentage of the principal.
- Maturity: The maturity indicates end of the bond investment tenure - the date on which the issuer must return the principal to the investor.
Example of Fixed Income as Investment Product
Consider a fixed income bond issued by a U.S.-based beverages company that is looking to raise capital to set up a bottling plant in Argentina. The issued bond is available at a face value of $1,000 each, and promises an annual interest rate of 5 percent and is due to mature in 5 years. Essentially, the company needs money now to build the plant, and expects to start making profits within five years from that venture which is when it will return the borrowed money to the investors.
Investors who believe in the business potential of this company may lend money by purchasing the bonds. In return for the funds lent to it, the firm compensates its bondholders by paying the fixed interest rate of 5% of the investment amount annually. If a bond investor purchases 10 bonds costing a total of $10,000, he will receive 5% x $10,000 = $500 as interest every year. This amount is fixed and represents a steady income to the bondholder. The company will receive the $10,000 and use and retain it for five years for the stated purpose for building the overseas plant. Upon maturity - that is, on completion of 5 years - the company will pay back the principal amount of $10,000 to the investor, while he would have additionally earned a total of $500 * 5 years = $2,500 as interest income from this fixed income investment. Investors may also have the option to sell the bond anytime in the open market to other interested investors before the five year maturity period. The interest is then paid to the bondholders on pro-rata basis, that is – depending upon the holding period.
Risks Associated with Fixed Income Investments
The primary risk associated with fixed-income investments is the issuer defaulting on his payments. Additionally, there is the credit risk linked to a corporate, and it can have varying effects on the valuations of the fixed income instrument till time to maturity. It is possible that a company issued a 10-year long bond when it was in its prime, while five years later its business started struggling due various factors and bond valuations started depleting. Though the company may (or may not) continue its regular coupon payments, it may become difficult for the investors to sell the bonds in open market at a fair price.
Fixed income instruments may also face liquidity risk, which indicates the inability to quickly buy/sell the security.
While government issued fixed income instruments are considered risk free, they may still face the risk of inflation that erodes the spending power of the earned money for the investors.
Fixed Income Investment as a Strategy
The term 'fixed income' in portfolio building generally refers to an investment style that generates stable and predictable returns. These returns are generated from low risk securities that pay predictable interest, and various methodologies can be employed to generate steady returns.
Building a fixed income portfolio may include investing in bonds as well as bond mutual funds, certificates of deposit (CD), and money market funds. These assets provide low but safe returns to the investors.
In a rising interest rate environment, the investor could purchase individual bonds, invest in bond funds, or employ the laddering strategy. With the laddering strategy, a portfolio manager can reinvest the principal of matured bonds into bonds with higher rates. For example, a $60,000 investment could be divided into a one-year, two-year, and three-year bond. When the one-year bond matures a year from now, the principal will be rolled into a two-year bond. When the two-year bond matures, the principal will be rolled into a three-year bond, and so on. By so doing the investor is able to take advantage of the higher interest rates as the years go by.
Fixed-income securities are recommended for investors seeking a diversified portfolio. The percentage of the portfolio dedicated to fixed income depends on the investor's personal investment style. There is also an opportunity to diversify the fixed-income component of a portfolio. For instance, one may have a portfolio with 50% in investment-grade bonds, 20% in Treasuries, 10% in international bonds, and the remaining 20% in high-yield bonds.
Investors looking for diversifying their portfolio choose to invest in the type of fixed income securities based on their risk appetite. While retired individuals generally tend to invest heavily in fixed-income investments because of the reliable returns they offer, junk bonds or high-yield bonds are attractive investments for investors looking for higher interest or income.