What is Fixed Income?

Fixed income securities pay investors a fixed or defined level of income at specified intervals. When the security matures, the investor receives the face value of the security. These are often bonds, which are debt securities issued by corporations, the U.S Treasury, state and local governments and federal governmental agencies.

Types of fixed income investments

Fixed income investments vary by the type of issuer, the length of time to maturity, their risk and a number of other factors.

Bonds

Bonds are fixed income vehicles that represent a loan from the bond buyer to the issuer of the bond. Bonds can be issued by corporations, state and local governments, governmental agencies and the U.S. Treasury. In general, bonds will have a specified face value, a stated rate of interest, and a set time at which the bonds will be redeemed for that face value. For example, a 30-year corporate bond with a par (face) value of $1,000 that pays a 4% interest rate will work like this:

• The bond holder will receive a $20 interest payment twice annually for each bond held.

• At the end of the 30-year period, the bond holder will receive their $1,000 back from the bond issuer.

Treasury securities

In order to finance the government’s debt, the U.S. Treasury issues several types of fixed income securities.

• Treasury bills or T-bills are short-term debt instruments with maturities ranging from four weeks to one year. T-bills are sold via an auction system and are sold at a discount. This means they are purchased at a price less than the note’s full value, the holder is paid the full face amount at maturity. This difference represents the interest rate on the bill.

• Treasury notes or T-notes are sold with maturities ranging from two to ten years. The 10-year notes are auctioned at set times during the year. These notes pay interest on a semi-annual basis.

• Treasury bonds are longer term debt instruments that mature in 30 years. They are auctioned monthly and pay interest semi-annually.

Certificates of deposit

Certificates of deposit or CDs are federally insured savings accounts issued by banks. They offer a fixed interest rate over a specified time period. Typically, with CDs you must leave your money in the CD until it matures or risk incurring a penalty such as lost interest.

Larger CDs can be bought and sold via brokerage firms. The price will vary based on factors like the direction of interest rates and others.

Bond funds and ETFs

Fixed income investors looking to invest via a professionally managed fund like a mutual fund or ETF have any number of options in this space as well.

There are mutual funds and ETFs that invest based on bond indexes like the Bloomberg Barclays US Aggregate Bond Index and a host of others. This is similar in approach to a fund or ETF that tracks a stock market index like the S&P 500.

There are a number of mutual funds, and some ETFs, where the fund invests in bonds on an actively managed basis. In this case the fund manager actively makes decisions about which fixed income securities to hold and not to hold. Buy and sell decisions are made over time in managing the portfolio.

Bond mutual funds and ETFs are available in a variety of categories. Morningstar lists 18 categories under taxable bonds:

• Long Government

• Taxable Bond Intermediate Government

• Taxable Bond Short Government

• Taxable Bond Inflation-Protected Bond

• Taxable Bond Long-Term Bond

• Taxable Bond Intermediate-Term Bond

• Taxable Bond Short-Term Bond

• Taxable Bond Ultrashort Bond

• Taxable Bond Bank Loan

• Taxable Bond Stable Value

• Taxable Bond Corporate Bond

• Taxable Bond Preferred Stock

• Taxable Bond High-Yield Bond

• Taxable Bond Multisector Bond

• Taxable Bond World Bond

• Taxable Bond Emerging-Markets Bond

• Taxable Bond Emerging-Markets Local-Currency Bond

• Taxable Bond Nontraditional Bond

As you can see, the funds invest in a range of bonds based on maturities, the type of bond as well as both bonds of U.S. and foreign based issuers.

Additionally, Morningstar has 16 categories of municipal bond funds. Some are state specific, others are national. Again, there is a range of maturities to choose from as well.

Risks of Fixed Income Securities

Here’s a breakdown of the risk by type.

Interest rate risk

Rising interest rates are the enemy of any bond investor. The price of a bond on the secondary market moves inversely with interest rates. If interest rates rise, the price of the bond will fall. For bonds held until maturity this really doesn’t matter. But for bond holders who might look to sell their bonds prior to maturity, the price they would receive will be reduced by rising interest rates. This is because in order for their bonds to be attractive to investors, the price must fall in order for the interest payments to equate to the yield newly issued bonds of a similar credit quality and maturity.

Default risk

With the exception of fixed income securities issued by the U.S. Treasury, some bonds may be at risk for default by the issuers. Defaulting on a bond entails a failure to make scheduled interest payments or to redeem the bonds at maturity. Default risk is sometimes referred to as credit risk.

An issuer defaulting on a bond or a series of bonds they have issued is representative of financial distress by the issuer. Default risk is an issue for corporate fixed income securities but can also occur with bonds issued by a state or local government.

Bond credit rating agencies will assign ratings to bonds based in large part on the financial strength of the bond issuer.

Inflation risk

Bond interest payments are generally a fixed amount that doesn’t increase or decrease based on the rate of inflation. An exception to this is Treasury Inflation Protected securities or TIPs that are indexed to inflation.

The fixed nature of these interest payments means that their purchasing power can be eroded during periods of high inflation. For those who rely on these periodic (generally semi-annual) interest payments as part of their annual income prolonged periods of inflation can be devastating.

Call risk

Some bonds carry a call provision which means that the issuer can redeem them under certain conditions. They may do this if interest rates have dropped allowing them to reissue a similar set of bonds at a lower interest rate. From the issuer’s perspective this lowers their cost of financing and debt service. Unfortunately, as the bondholder in this situation, when a bond is called away you lose out on the remaining interest payments at the higher rate. The bond issuer will redeem the bond’s face value, so the bondholder doesn’t lose anything that way.

When looking at a bond with a call provision, a fixed income investor should look at both the bond’s yield to maturity, but also its yield to worst, defined as the bond’s yield to the earliest point at which it might be called.

Prepayment risk

This is most common with mortgage-backed bonds such as those issued by some government agencies that securitize pools of mortgages, This is similar to call risk in that if holders of the underlying mortgages prepay their loans, this can cause the bonds to be redeemed sooner than anticipated. This situation might arise during a period of falling interest rates where mortgage holders look to refinance higher rate loans.

Liquidity risk

The secondary market for individual bonds is different than buying and selling individual stocks, ETFs or other exchange traded instruments on the stock exchanges. The bond market is often less liquid than the stock market, which can cause some delays in being able to sell a bond. It can also cause a degree of price fluctuation as the secondary market for bonds tends to one where buyers and sellers become matched up. This can sometimes lead to a large spread between the price the seller thinks they will get and the price a willing buyer of the bonds is willing to pay.

This type of situation doesn’t generally exist in the market for Treasury securities where there is an active secondary market that provides good liquidity for bond holders.

Duration risk

Represents the risk of things that can happen over time. Duration is a concept that considers the time to maturity and the present value of a bond’s cash flows. In general, a bond with a linger time to maturity will be more sensitive to changes in interest rates in terms of the potential impact on the bond’s price.

In the bigger picture, the longer the duration of the fixed income security’s term until maturity, the more bad things that can happen. The longer the time to maturity will generally add greater risk to any fixed income vehicle.

Investing in fixed income securities can help diversify an investor’s portfolio. The type of fixed income vehicle should be chosen based on a number of factors including their risk profile and time horizon for the money.