Guide To Fixed Income Investing (2024)

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For most investors, stocks and bonds go together like peanut butter and jelly. They’re the two main pillars of a well-balanced portfolio, the key ingredients in your long-term wealth.

While stocks get headlines, fixed income is a more low-key source of cash flow and capital preservation. Often, when stocks are declining in value, fixed income is gaining in value, making them an important hedge

The bond market also happens to be much larger than the stock market. But deciding on what types of fixed income you should own depends on factors like your age and risk tolerance.

What Is Fixed Income?

A city wants to build a new school; a company is looking to expand production. The federal government needs to support poverty-stricken children. A company needs to expand production.

These entities borrow money by selling bonds, which is just another word for fixed income.

Fixed income debt securities are issued with a specific maturity date and interest rate—the so-called coupon. During the life of the bond, interest payments are made on a regular basis, typically twice a year. At maturity, the issuer repays the principal, or par value, of the security.

Dependable and timely payments is why fixed income is such a desirable asset, especially for older retirees. Of course, there are trade-offs.

Inflation can eat away the value of the bond’s interest payments, while struggling companies may not make good on their debt obligations.

And if you own a basket of bonds in a mutual or exchange-traded fund, rising interest rates from the Federal Reserve could cause the value of your investment to go down.

How Fixed Income Works

To illustrate how fixed income securities work, let’s assume Acme Corporation needs to raise capital for a new production facility.

Acme has the highest possible bond rating and needs $10 million in funds. The company prepares to sell bonds with a par value of $1,000.

If an investor purchases a bond directly from Acme, they pay the face value. Bonds trade in the secondary market, and may trade above par, at a premium, or below par at a discount.

Let’s assume we buy the bonds directly from Acme and hold them to maturity. The bonds pay 4% semiannually on the face value of $1,000 and mature in 10 years.

Under this scenario, each bond pays $40 annually in two payments of $20 each. At the end of 10 years when the bond matures, the bondholder will be repaid the $1,000 principal and will have earned $400 in interest.

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Types of Fixed Income

There are many different types of fixed income securities, and each one is characterised by unique features, including tax treatment.

Government bonds are the most secure fixed income investments, especially those backed by the full faith and credit of the United States.

  • Treasury bills. Also known as T-bills, treasury bills are issued with maturities between a few days and 52 weeks. They are the shortest-term government bonds, and they do not pay a coupon. Investors buy these bonds at a discount to their par value and the return comes from the difference between the discounted purchase price and the face value received at maturity.
  • Treasury notes. Also called T-notes, treasury notes are issued in maturities between two and 10 years. Typical maturities are two, three, five, seven and 10 years. They pay a fixed coupon rate and are issued at increments of $100. The investor will receive semiannual coupon payments during the life of the bond, and the principal at maturity.
  • Treasury bonds. Generally called T-bonds, these are the longest-duration government bonds, issued with maturities of 20 and 30 years. Like T-notes, they’re sold in increments of $100 and pay the coupon semiannually.
  • Treasury Inflation-Protected Securities. Also called TIPS, these fixed-income securities offer investors protection against inflation. The principal increases with inflation and decreases in the event of deflation, as measured by the consumer price index (CPI). When the bond matures, the investor receives the greater of the inflation-adjusted principal or original face value. TIPS pay interest twice annually at a fixed rate. Since the interest rate is applied to the adjusted face value, interest payments rise with inflation and fall with deflation.
  • Municipal bonds. Commonly called munis, state governments, municipalities or other governmental agencies issue this form of fixed income. In most cases, municipal bonds offer significant tax benefits, such as exemption from federal income tax. You receive semi-annual payments and the return of the principal at the date of maturity.
  • Corporate bonds. As the name suggests, corporations sell these types of fixed income securities. The yield typically depends in part on the creditworthiness of the issuer. The higher the credit rating, the lower the coupon rate, since they’re deemed more likely to pay back the principal.
  • High-yield bonds. Also known as junk bonds, these securities are typically issued with higher coupon rates than investment-grade bonds due to lower credit ratings and greater risks of default.

Fixed Income Advantages

Diversification

Investors never want to have their eggs in one basket. Take 2008, for instance. Stocks dropped 37% in that terrible year, while Treasury bonds jumped 20%.

It is true that stocks tend to beat bonds over the long haul, but you’re better off moderating your risk, especially in the near term.

Income Generation

Due to the fixed coupon payments that investors receive at specified intervals, bonds can provide a steady and predictable flow of income.

In the case of municipal bonds, the income is exempt from federal income tax and may be exempt from state income tax if the purchaser resides in the state when the bond has been issued.

Capital Preservation

Bonds make sense for money that you’ll need in five–to–10 years, an important consideration for retirees who are more sensitive to portfolio volatility as they have less time to recoup losses.

Fixed Income Risks

Interest Rate Risks

Fixed income securities are very sensitive to changes in interest rates. When rates rise, bond prices fall. Conversely, when rates fall, prices rise.

These price changes impact the value of the fixed income investment. Movements in interest rates tend to cause price volatility in the bond market, and the risk is higher for longer duration bonds. That’s one reason why the total return on bond funds have performed so poorly throughout 2022.

Inflation Risks

Bonds provide a regular income stream, but the purchasing power of this income can deteriorate when inflation rises.

Credit Risk

Credit risk is the extent to which a company might be likely to default, in which case the bondholder could lose some, or all, of their principal.

While fixed income securities are subject to credit risk, credit ratings from bond ratings agencies like Moody’s Corporation or Fitch Ratings offer a dependable estimation of an issuer’s risk.

Highly-rated securities are conservative investments and attractive to investors seeking capital preservation in addition to income. The lower a bond’s level of risk, the lower the coupon payment.

Liquidity Risks

This is the risk that a bondholder may be unable to sell a fixed income security due to a lack of buyers. In an illiquid market, an investor may be forced to sell at a lower price than they paid for the investment.

Call Risks

This is the worry that a borrowing entity, like a school district, repays its debt quicker-than-expected, thereby depriving you of the interest payments.

While you’d be able to reinvest the principle elsewhere, you may have to do so at worse terms, depending on economic conditions.

How To Invest In Fixed Income

Bonds always have a place in your investment portfolio. Younger investors can take more risk and can allocate more assets to equities, but they’ll still have at least some money in bonds for diversification.

As investors age, risk tolerance declines and the allocation to fixed income rises. At retirement, many investors choose a large allocation to fixed income due to their income and capital preservation needs.

Every investor must assess their risk tolerance and stage in the investor life cycle to determine their asset allocation.

While retail investors can buy bonds directly from the issuer, this can be challenging. Purchasing bonds in the secondary market through a broker could entail high transaction costs and high investment minimums. Moreover, building a diversified bond portfolio requires significant investment.

The easiest way for the individual investor to access diversified fixed income investments is through bond mutual funds and bond exchange-traded funds (ETFs).

  • Fixed Income Mutual Funds. These funds are a popular way for average investors to own fixed income. A mutual fund pools together investor dollars and uses that capital to buy different securities, including bonds. There are various types of bond funds, and even funds that own both stocks and bonds, such as balanced funds. These securities tend to hold a basket of bonds, giving you increased diversification.
  • Bond Exchange-Traded Funds (ETFs). Fixed income ETFs work similarly to mutual funds—investors pool their money and buy shares of the portfolio—but they are traded on a public exchange. You can find offerings based on specific characteristics such as credit rating and duration, among other features.

Given the challenges that accompany fixed income investing, it’s always wise to ask for advice from a fee-only financial advisor.

I'm an expert in finance and investments, with a deep understanding of the dynamics between stocks and bonds, particularly in the context of building a well-balanced portfolio. My expertise is grounded in practical knowledge and experience, allowing me to provide valuable insights into the intricacies of fixed income securities.

Now, let's delve into the concepts covered in the provided article:

1. Overview of Stocks and Bonds: The article emphasizes the symbiotic relationship between stocks and bonds in a well-balanced portfolio. While stocks grab headlines, fixed income serves as a more low-key source of cash flow and capital preservation. This balance is crucial for long-term wealth.

2. Fixed Income Defined: The article explains that entities like cities, companies, and governments borrow money by selling bonds, which are synonymous with fixed income. These fixed income debt securities have specific maturity dates and interest rates, providing dependable and timely payments.

3. Types of Fixed Income: The article outlines various types of fixed income securities, including government bonds (Treasury bills, notes, bonds, and TIPS), municipal bonds, corporate bonds, and high-yield bonds. Each type has unique features, such as tax treatment and creditworthiness considerations.

4. How Fixed Income Works: Using an example of Acme Corporation raising capital through bond issuance, the article illustrates how fixed income securities work. It explains the concept of coupon payments, bond maturity, and the potential return on investment.

5. Advantages of Fixed Income: The article highlights diversification, income generation, and capital preservation as key advantages of fixed income. It explains how bonds can provide a steady income stream, especially municipal bonds with tax benefits.

6. Risks Associated with Fixed Income: The article discusses various risks, including interest rate risks, inflation risks, credit risks, liquidity risks, and call risks. It explains how changes in interest rates can impact bond prices and the potential challenges associated with creditworthiness and market liquidity.

7. How to Invest in Fixed Income: The article suggests that bonds should always have a place in an investment portfolio. It advises on adjusting the allocation of fixed income based on investor age, risk tolerance, and investment goals. Additionally, it recommends accessing diversified fixed income investments through mutual funds and exchange-traded funds (ETFs).

In conclusion, the article provides a comprehensive overview of stocks and bonds, delving into the nuances of fixed income securities, their advantages, associated risks, and practical advice on investing in this asset class.

Guide To Fixed Income Investing (2024)
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