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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
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.
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.
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.
Bonds provide a regular income stream, but the purchasing power of this income can deteriorate when inflation rises.
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.
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.
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 enthusiast with extensive knowledge in the field of investment, particularly in stocks, bonds, and fixed income securities. My experience includes hands-on involvement in analyzing market trends, understanding various types of financial instruments, and providing valuable insights to investors.
Now, let's delve into the concepts covered in the article you shared:
Introduction to Stocks and Bonds:
- The article highlights stocks and bonds as the main pillars of a well-balanced portfolio.
- Emphasizes fixed income as a low-key source of cash flow and capital preservation.
What Is Fixed Income?
- Explains that entities like cities, companies, and governments borrow money by selling bonds, which are a form of fixed income.
- Defines fixed income debt securities with specific maturity dates and interest rates (coupon payments).
How Fixed Income Works:
- Illustrates the process of a company (Acme Corporation) raising capital by selling bonds.
- Details the payments, both interest and principal, over the life of the bond.
Types of Fixed Income:
- Government bonds, including Treasury bills, notes, and bonds.
- Treasury Inflation-Protected Securities (TIPS) that offer protection against inflation.
- Municipal bonds with potential tax benefits.
- Corporate bonds, influenced by the creditworthiness of the issuer.
- High-yield bonds, also known as junk bonds, with higher risks and coupon rates.
Fixed Income Advantages:
- Diversification: Stocks and bonds provide diversification to mitigate risks.
- Income Generation: Fixed coupon payments offer a steady income flow.
- Capital Preservation: Bonds are suitable for preserving capital over 5–10 years.
Fixed Income Risks:
- Interest Rate Risks: Sensitivity to changes in interest rates affecting bond prices.
- Inflation Risks: Purchasing power erosion when inflation rises.
- Credit Risk: Likelihood of default by the issuer.
- Liquidity Risks: Difficulty in selling a fixed income security due to a lack of buyers.
- Call Risks: Concerns about early debt repayment affecting interest payments.
How to Invest in Fixed Income:
- Allocation changes with age; younger investors can take more risk, while retirees may allocate more to fixed income.
- Buying bonds directly or through brokers, but challenges include high costs.
- Accessibility through fixed income mutual funds and bond exchange-traded funds (ETFs).
The article concludes by recommending seeking advice from a fee-only financial advisor due to the challenges associated with fixed income investing. If you have any specific questions or need further clarification on any aspect, feel free to ask.