Fixed-income securities are an essential part of many investors’ portfolios. Many consider them a low-risk investment option that provides a steady income stream through interest payments.
The biggest hurdle with this investment is grasping how they work though. The good news is that once you understand the basics, the rest falls into place.
In this article, we’ll explore the basics of bonds, including how they work, the different types of bonds available, and the risks you must be aware of.
What Are Fixed Income Securities?
Fixed-income securities have many names, with the most common being bonds. When you purchase bonds from a corporation or the government, you lend them your money.
For example, if a company needs cash to expand, it will issue bonds. This leaves the company indebted to whoever buys them.
All bonds have a face amount, maturity date, and an interest rate. You might hear terms like coupon rate or yield. Know this is the same as the interest rate.
If you buy fixed-income securities, you might purchase a bond with a face value of $1,000 that matures in 20 years and pays 5% interest.
The interest payments, or coupon payments, are paid semi-annually or every six months with most bonds. At maturity, you get your $1,000 investment back.
Regarding fixed-income investing, know that it works slightly differently from the stock market. With the stock market, demand pushes stock prices higher, and investors profit from the increase in share price. With bonds, demand will also push prices higher. But when bond prices increase, bond yields fall.
Suppose you buy a $1,000 bond that matures in 10 years and pays 5% interest. If inflation rises from 2% to 8%, new bonds that are issued might pay 9%. Demand for your bond will decline since no one will want to purchase a bond paying 5% when they can buy one paying 9%.
To sell your bond, you will have to sell it for less than face value. Doing this will allow the new investor to earn the 5% interest rate and a return when they redeem the bond at maturity. If you sell your bond for $900, the new investor will receive $100 extra in addition to the 5% interest.
The reverse is also true. If inflation drops from 5% to 2% and you have that same security, there will be greater demand since new bonds will pay a lower interest rate. This means you could sell your bond for more than face value.
Of course, there is no requirement for you to sell your bond in either of the scenarios. You can hold it until it matures and collect your initial investment back.
Now that you have a basic idea of how bonds work, let’s look at the different types you can invest in. (And if you still need more examples of how bonds work, you can check out the best investing YouTube channels.)
Types of Fixed Income Securities
Many types of fixed-income investments are out there, and it is important to know them because they carry different risks and interest rates.
Here is a list of the more common ones you will come across.
Treasury bills, commonly known as T-bills, are a type of short-term debt instrument issued by the federal government through the US Department of Treasury. These bills have a maturity period of less than one year and are a low-risk investment option for individuals and institutional investors.
Unlike other fixed-income products, T-bills are sold at a discount, meaning that investors can purchase them at a lower price and then receive the full face value when the bills mature.
The interest earned is the difference between what you paid and the amount you get when it matures.
Although they may not offer high returns, the low-risk characteristics of T-bills have made them a popular choice for investors seeking a safe place to park their money in the short term.
Treasury notes are government bonds with a maturity date between two and ten years. They pay a higher interest rate because they have a longer maturity compared to other Treasury investments.
The downside is that they are subject to interest rate and inflation risk, which could impact the interest you earn. For example, if you earn 4% on a 10-year note and inflation is 2%, you are outpacing the increase in prices.
However, if inflation spikes to 6%, you are stuck with an investment that is not keeping up with rising prices and, as a result, is losing purchasing power.
Treasury bonds have the longest maturity dates of all government debt, maturing in 30 years.
Because of the long duration of these bonds, investors are subject to interest rate and inflation risk, more so than with shorter-duration Treasuries.
Treasury Inflation-Protected Securities
Inflation-protected securities, or TIPS, offer investors a safeguard against inflation. These bonds provide a fixed rate of interest, but their overall value adjusts in response to changes in the Consumer Price Index (CPI).
As inflation fluctuates, the principal value of these securities also fluctuates, ensuring that investors’ returns keep up with inflation.
Investing in TIPS can safeguard their purchasing power and ensure their investment returns do not erode over time.
Municipal bonds are debt instruments issued by local governments to fund projects. You might see bonds for upgrading sewer systems, building a new school, or repairing roads.
These securities carry more risk than government debt securities but less than corporate debt obligations.
Corporate bonds are debt issued by companies to help fund new projects and overall growth. They are riskier than government bonds but are still safer than stocks.
When investing in corporate bonds, know there are two main types, investment grade bonds and non-investment grade bonds, or junk bonds.
Independent agencies rate companies according to their financials. If a company has solid financials and is not at risk of going bankrupt, its debt instruments receive a high score and are considered investment grade. They receive a non-investment grade rating if their financials are not as strong. This does not mean the company will go bankrupt.
Instead, it is a rating system that some bond funds use to help determine how to invest their money. Additionally, some institutions will not invest in junk bonds, so the ratings make it easier to know what they can and cannot invest in.
Because corporate bonds carry a higher risk, including credit risk, they tend to pay higher rates than government bonds.
International bonds are bonds in foreign governments or corporations. They tend to pay a higher yield because of additional risks associated with investing in foreign countries.
These risks include foreign currency risk, the impact of a rising or declining currency, or political risk, where the government might not repay future debt obligations.
A zero-coupon bond is a bond that does not pay interest. Instead, it sells at a deep discount to par value.
When the bonds mature, the investor earns the face amount. For example, a bond might have a face value of $10,000 and sell for $1,000.
When looking at these securities, you will see a coupon rate listed. This is the difference between what you pay and the value of the bond. Some call this the imputed interest or phantom interest.
Certificates of Deposit
Though a bank CD is not what many would think of when discussing fixed income, they qualify. When you invest in a CD, the bank turns around and uses that money to fund loans to other customers.
The primary benefit of CDs is that they are insured by the Federal Deposit Insurance Corporation, meaning as long as you have less than $250,000 invested, you will not lose your money.
Individual Bonds vs. Bond Funds
Investing in individual bonds is more challenging than other investments, except for possibly investing in options, primarily because bonds generally sell for $1,000 each, also known as par value.
Additionally, if you want a diversified portfolio, you need to purchase bonds from different companies and governments for different maturity dates.
Because of this, you can invest in bond ETFs and mutual funds. In both cases, bond investors purchase shares of the fund and own various bonds. This makes it easier for individual investors to invest.
However, the downside of bond funds is that you do not have control over when the fund sells a bond. This opens you up to the potential of losing money if the fund sells a holding before maturity.
When investing in individual bonds, you have complete control over when you sell, avoiding this risk.
Types of Risks With Fixed Income Securities
There are a handful of important risks to be aware of when investing in bonds. Here is a rundown of the four major risks investors need to know.
Default risk refers to the possibility of a bond issuer failing to make interest payments or return the principal amount. An investor runs the risk of not receiving their expected return because the issuer might go bankrupt or default on their bond.
Liquidity risk is the possibility that one may not be able to sell their bonds for fair value when they need to. It occurs when investor demand for the bond falls short, lowering the market’s liquidity and making it harder to sell the bond. As a result, the bond owner might have to sell the security for much less than planned.
This risk arises because bonds have fixed yields, meaning they don’t adjust for inflation. As a result, if inflation increases, the real return on a bond investment can decrease.
To mitigate inflation risk, investors may choose to invest in inflation-protected securities or focus on shorter-term bonds with less exposure to inflation over time.
Interest Rate Risk
This risk refers to the potential for interest rate changes to affect a bond investment’s value.
When interest rates rise, the value of existing bond holdings typically declines. Conversely, if interest rates fall, bond prices tend to go up. This risk is especially important when investing in longer-term bonds, as they are more sensitive to interest rate changes than short-term bonds.
Advantages of Fixed Income Securities
If you are considering investing in fixed income, here is a summary of the advantages.
- Low-risk investment compared to stocks
- Regular interest payments
- Investors know their return before investing (assuming they hold until maturity)
- Diversify stock portfolios helping to reduce risk and volatility
Drawbacks of Fixed Income Securities
Of course, there are downsides to investing in fixed income as well. Here is a summary investors need to know.
- Lower return compared to stocks
- Fixed interest income for the life of the bond
- Bankruptcy and other risks that could impact the value of the bond
Overall, investing in fixed-income securities is an excellent option for many investors, especially those looking to invest in low-risk alternatives to the stock market and those looking for a reliable income stream.
But this does not mean other investors cannot benefit from bonds. Having a small portion of your portfolio invested in fixed income helps to lower volatility and reduce the potential for greater losses.
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This article originally appeared on Wealth of Geeks.
Jon is the founder of MoneySmartGuides, which helps people dig out of debt and start building wealth so they can achieve their dreams. He has over 15 years of experience in the financial services industry and 20 years of investing in the stock market. He has both his undergraduate and graduate degrees in Finance and is FINRA Series 65 licensed, and has a Certificate in Financial Planning.