When most investors consider returns on their investments, they immediately think about an asset increasing in price and being sold at a higher price than purchase. While this is the traditional way investments provide returns, some types of investments generate income through dividends or interest payments.
Fixed-income investments are a cornerstone of many portfolios, offering steady returns and reduced risk compared to equities. For investors seeking reliable income or a way to diversify their holdings, fixed income can provide stability and peace of mind. Let’s take a closer look at the types of fixed-income investments, how they work, and who they’re best for.
What Is Fixed Income?
Fixed income refers to investments that provide regular, predictable returns, typically in the form of interest payments, and return the principal at maturity. In addition to playing a crucial role in generating steady income for investors, these investments help reduce portfolio volatility by offering stability and acting as a counterbalance to more volatile assets like stocks, especially during market downturns. The tradeoff for these investments is usually a lower rate of growth potential.
Types of Fixed Income Investments
There are many different types of fixed-income investments, each suited to different financial needs. Common options include:
Government Bonds
Government bonds are debt securities issued by national governments to fund public spending, making them one of the safest investment options available. Backed by the full faith and credit of the United States, these bonds offer predictable returns, and their low-risk nature makes them appealing to conservative investors. Examples include U.S. treasury bills and notes, which offer tax-exempt interest payments.
Corporate Bonds
Corporate bonds are issued by companies seeking to raise capital for business activities like expansion and new product releases. These bonds usually offer higher yields than government bonds but come with a higher risk of default compared to local government bonds.
Municipal Bonds
Similar to government bonds, municipal bonds are issued by small local governments to fund projects like road and hospital construction. While they may not offer the highest returns, their significant tax advantages can make them appealing, as income is exempt from federal and often state and local income tax calculation.
Fixed-Income ETFs and Mutual Funds
Both fixed-income exchange-traded funds (ETFs) and mutual funds pool funds from multiple investors to create a diversified portfolio of bonds and other fixed-income securities. An example is the JPMorgan Ultra-Short Income ETF (NYSE: JPST), which generates income from short-term debt investments. These funds may provide both immediate returns and long-term growth but also come with more risk than bonds.
Certificates of Deposit
Certificates of Deposit (CDs) are low-risk, fixed-term investments offered by banks and credit unions. In exchange for locking in a fixed amount of money for a set term, you receive interest paid out at a predetermined rate. CD terms can range from a few months to several years, with longer terms garnering more interest income.
Benefits of Fixed Income Investments
Fixed-income investments can be appealing to investors looking for low-risk, immediate returns on their funds. Some of the reasons why investors choose fixed-income assets include:
- Predictable Returns: Fixed-income securities provide regular interest payments, making them ideal for investors who need steady cash flow, like retirees.
- Lower Volatility: Government and high-quality corporate bonds are less volatile than stocks, offering stability in uncertain markets. This can introduce a level of protection against loss, which becomes especially important as you prepare to exit the market.
- Diversification: Adding fixed-income investments to your portfolio can help you protect your investments during times of uncertainty. Their lower-risk nature helps balance the volatility of equities and other high-risk assets.
Risks of Fixed Income Investments
While fixed-income investments are less risky than options like stocks, they are not immune to risk all together. Some potential drawbacks to consider include:
- Interest Rate Risk: Rising interest rates can reduce the market value of fixed-income securities, as new issues may offer higher yields. And if you’re locked into a bond or CD timeline, you can’t immediately pull out your investments and re-invest at a higher rate.
- Inflation Risk: Rising inflation can also affect your returns as fixed payments lose purchasing power in high-inflation environments, eroding real returns.
- Credit and Default Risk: Corporate bonds and even some municipal bonds carry the risk of issuer default, potentially leading to loss of principal or missed interest payments. While this isn’t as likely as a drop in share price, focusing on federal bonds would minimize your risk of loss as much as possible.
- Liquidity Risk: Certain fixed-income instruments, especially those with lower credit ratings or longer maturities, can be harder to sell quickly without taking a loss. For example, if the credit rating of a corporation drops and there is virtually no demand for the bond, you could be locked into your investment until market conditions change.
Is Fixed Income Right for You? Take Our Quiz
Determining if fixed-income investments are right for you doesn’t need to be difficult. Start by asking yourself these questions:
What is my investment timeline?
Fixed income investments are most suitable for investors on a shorter timeline. While these assets may not increase in value as rapidly, they offer an immediate return on investment. For example, if you’re a year or two off from retirement, these investments can provide income to support you.
Am I comfortable with the lower returns compared to equities?
Fixed-income assets do not appreciate in value at the same rate as growth stocks. Know that the tradeoff for an immediate return is lower long-term returns.
How much of my portfolio should be allocated to fixed income?
The answer depends on factors like your age, risk tolerance, investment goals, and time horizon. Here are some general guidelines:
- Age-Based Rule: A traditional rule of thumb is to allocate a percentage of your portfolio to fixed income equal to your age. For example, if you're 40, consider 40% in fixed income.
- Risk Tolerance: Conservative investors can allocate 50-70% to fixed income for stability and regular income; moderate investors typically allocate 30-50%, balancing stability with growth; aggressive investors can allocate 10-30%, prioritizing growth over stability.
- Investment Goals: If you have short-term goals, you should allocate more to fixed income as it provides safety and liquidity. A smaller allocation allows more growth potential through equities for those with longer-term goals.
- Time Horizon: If you're nearing retirement, increasing your fixed-income allocation can preserve capital and provide regular income. Younger investors with a longer time horizon can afford a smaller allocation and take on more equity risk for growth.
Do I understand the risks of different types of fixed income?
Each type of fixed-income security carries unique risks, including interest rate, credit, inflation, and liquidity risks, which can impact returns and capital preservation. Not every type of income-producing investment is suitable for conservative investment portfolios. Understanding these risks ensures your choices align with your financial goals, risk tolerance, and investment timeline.
Am I investing for income, capital preservation, or diversification?
Are you investing to generate steady income through interest payments to supplement earnings or retirement funds? Is your goal preserving capital, focusing on protecting your initial investment from market volatility while accepting lower returns? Or, are you seeking diversification, using fixed-income assets to balance the risk of more volatile investments like stocks and reduce overall portfolio volatility? Identifying your purpose ensures your investment choices align with your financial goals.
Finding Balance with Fixed-Income Investments
Fixed-income investments are essential to many portfolios, offering predictable returns, stability, and diversification. While they may not provide the high growth potential of equities, their lower risk and steady income make them a reliable choice for conservative investors, retirees, and those seeking to balance volatility in their holdings. By understanding the types of fixed-income securities, their benefits and associated risks, you can determine how they fit into your financial strategy and help you achieve your long-term goals.
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