Fixed income investments are very important to investors who are looking for a balanced investment portfolio. Many people conclude that fixed-income investments are not as charming as the stock market. However, investing in fixed income securities like bonds can be quite useful, earning periodic interest payments and a mature principal in the end. You can easily predict your exact future cash flow to structure your portfolio to your financial needs. However, if you are looking to get some investment education you can check what we offer here.
Fixed income is a kind of investment that usually results in fixed or predictable returns paid regularly (quarterly, monthly, annually). Just like equity, fixed income constitutes a very crucial part of investment markets.
Explaining-Fixed Income Investments
Fixed income investments typically include bank certificates of deposits, bonds and so on. It mostly, if not always, involves strategies that are like loans, whereby someone borrows money from an investor upfront with the promise to pay it back at a later date.
Fixed income investments play a strategic role in helping preserve principals, generate income and stabilise overall investment returns. By staggering fixed income maturities, an investor can provide liquidity for both expected and unexpected needs. Hence fixed income investments should not be entirely focused on yield but should also be structured to return principal on the stated maturity date.
How do fixed income investments work?
Fixed income investments will provide you periodic income payments at a dividend or interest rate that will be known in advance. The most popular fixed-income investments are corporate bonds, Treasury bonds, preferred stock, and certificates of deposit.
If you decide to hold fixed-income investments in the form of Treasury bonds and CDs, you will receive a fixed interest rate based on a par value over a specific period. However, if you decide on holding a preferred stock, you are entitled to a periodic fixed dividend that is detailed by the company that issued the stock for as long as they own the shares.
Investing too conservatively may expose a portfolio to inflation risk, because smaller returns may not keep pace with rising prices. Another reason for using fixed income investments is to reduce overall portfolio risk. When investing in stocks, an investor becomes a company shareholder, with no guarantee of either a continued dividend or rising stock price. On the other hand, fixed income investments specify a rate of return and provide for the return of principal at a future date. However, remember that the risk of default could result in a loss of your investment.
This is because fixed income investments generally don’t move in tandem with stocks. They provide a source of return with generally lower volatility and thus can be an essential diversification tool in reducing the overall investment risk of a portfolio.
When looking for ways to achieve higher yield, it is important for investors not to assume too much credit risk or interest rate risk. Investors become exposed to credit risk when evaluating the likely hood of a default by the issuer of the dept. The lowest credit risk such as Treasury securities backed by the US government is deemed to be risk-free and carry the lowest yields.
Treasuries are followed on the risk spectrum by:
- FDIC-Insured CDs guaranteed by the FDIC up to the amount of applicable insurance.
- Debt issued by federal government agencies.
- Highly rated municipal or corporate debt
- Emerging market dept.
The highest yielding fixed income categories come from investments in those entities deemed most likely to default. Another way to achieve a higher yield is to accept interest rate risk by investing in longer maturities. In normal market conditions. Investors are paid higher yields when they are willing to commit their money for more extended periods. However, if interest rates rise and the investor does not hold the bonds until maturity they may be a loss of principal because of bonds. There may be a loss of principal because of the bond price.
Risks of fixed income investments
Fixed income investments considerably have fewer risks than stocks. However, right as this may be, fixed income investments do have a few threats of its own, and you are going to find out which ones:
This is whereby something happens to the borrower and may not be able to repay the loan which leaves you with a loss. This is the worst that could happen because you will not only lose your income stream; you will also lose the income investment you made. You may be able to get your principal back though not guaranteed.
Investors who intend to live off their fixed income are particularly concerned about the risk of inflation. However, it is a factor that all investors should consider. Fixed income typically deals with the trading of money at the present moment with hopes of receiving money at a later date. Therefore the concern is that inflation will rise which will decrease your income’s purchasing power.
Interest rate risk
You stand the chance of being locked in a low rate fixed income investment if the current interest rates go up. This will be so until the investment matures. The falling of fixed income investments prices is also caused by rising rates. However, if interest rates decline, bond prices usually go up. Which typically means an investor could sell for higher than face value.
A callable bond allows the issuing party to call or redeem the bond before it matures. If interest rates decrease, the person who issued the bond can repay the callable bonds and issue out new bonds
at a lower interest rate and save money that way. However, if this is to happen, the bond holder’s interest payments will stop, and they will get their principals earlier.
Prepayment risk mostly affects classes of individual bonds such as mortgage-backed bonds. The danger is that the principal will be repaid by the issuer before it matures. This will ultimately disrupt the payment plan of the bond. Prepayment risk is more predominant with the mortgage-backed bond in which refinancing is initiated by a mortgage rate decrease.
With liquidity risk, the concern is that one may not be able to sell or buy fixed income investments fast enough to catch the closest price to the actual value of the asset. A ‘liquid bond’ generously means that there is a relatively large market of investors who are trading this particular type of bond. Large issues like treasury bonds are quite liquid. However, it is not all bonds that are liquid. For example, municipal bonds rarely trade, hence selling before maturity may be problematic. If there are less and fewer people with intentions to buy the bond that you are selling you will probably lower your price and be at a loss. The risk is much higher with bonds that have been recently downgraded or that were a fraction of a smaller issue.
Now finally considering the nature of the bond market, being ripped off is one of the inevitable risks that need to be considered. Different from the stock market
which includes transparent transaction, the bond market is almost always like you are walking with blindfolds and hoping not to fall. Reason being that bonds are traded over the counter (OTC) as opposed to in the secondary market via exchanges. The rules of exchange do not apply to over the counter transactions because the trade occurs directly between two people. Therefore, uninformed trading over the counter can be quite risky for individual investors. However, there are systems like the Trade Reporting and Compliance Engine that tries to make adequate information available for individual bond investors. Nevertheless, average investors must stick to safer ways and places to do business.
Tips on how to protect your fixed-income investments from inflation
Although fixed income investments can provide a safe place for investors, who wish for consistent returns and are wanting to avoid the volatility of the stock market. There is the biggest downside, in my opinion, is that inflation can drastically decrease your real returns.
Worried? Here’s what to consider doing
1. Don’t panic
is a factor that should not be taken lightly by all investors when it comes to decision making. Just like any other market forces, you must make sure you always make a rational decision when it comes to any changes made to your portfolio due to effects. Think of the long-term goals rather than rushing to make decisions based on current changes or market forces.
2. Fixed income investments diversification
Typically fixed income investments are quite sensitive to inflation. However, there are quite a few categories of fixed income investments that are more immune to inflation than others. Investing in only one fixed income security is not going to protect you instead diversify into a variety of fixed income instruments and be more at ease. For example, if you shorten your bonds and bond funds duration, you can reduce the impact of increasing rates. This is because short-term bonds give you the chance to lock in the present rates and still purchase at higher rates new investments when short-term ones mature.
3. Historical point of view of portfolio
Fixed income investments may not offer adequate returns to accommodate inflation in the long run for investors that have a long time limit. However, you can use equities to balance out your fixed-income investments to grow and diversify your portfolio more.
Final thoughts - what to invest in and what to avoid
What to consider:
A diversified portfolio is significant, therefore consider a diversifying in short-term bonds. Short-term bonds will pay more with high-interest rates as compared to money markets. However, when the interest rate goes up short-term bonds will lose less principal than long-term bonds.
Fixed annuities are quite valuable to taxable investment accounts because their income is tax-deferred. It is also very crucial to acknowledge that if interests rates rise fixed annuities will not lose principal.
What to avoid
Intermediate or long-term bonds
Try to avoid long-term bonds because the moment interest rates go up they will lose quite a lot of principal. Instead, opt for short-term bonds for approximately less than three years.
These funds have an average maturity of about 12 years and hold 40 percent -60 percent bonds. This ultimately means that as a result of higher interest rates, half of the investments associated with these funds will lose money.
I hope you found this article helpful. Also, hopefully, you learned something that can help you achieve everything that you want; since fixed income investments are the thing to go for if you are looking for a balanced portfolio. However, if you are looking to find more trading strategy than just what fixed income investments are; you can check out our trading strategy here