Fixed income does exactly what it says on the tin: these debt securities provide you with regular fixed interest payments until they mature, at which point you’re paid back your principal amount. The term length of fixed income investments can vary widely, from a few weeks or months to 30 years or more. The interest amount that you receive is predetermined and remains the same throughout the life of the investment.
Fixed income investments are a great way to diversify your portfolio without taking on much risk. Their steady interest payments also offer capital preservation benefits during equity market fluctuations, and they can be used as a source of income if you need to access funds but don’t want to sell off investments — one reason fixed income products feature prominently in retirement portfolios.
Types of fixed income
Fixed income instruments vary in structure, term length, quality, and risk level. Some types include:
Bonds
Bonds, the most common type, are loan agreements between bond issuers (such as sovereign governments, municipalities, or companies) and bondholders (individual or institutional investors). Issuers agree to pay bondholders a set interest rate over the life of the bond and repay the principal amount at its maturity date. Bonds can be issued by federal, state, and local governments, as well as corporations, nonprofits, and agencies.
Treasury bills
Also called T-Bills, these notes are very short-term Canadian government debt obligations backed by the full faith and credit of the Government of Canada.
Guaranteed investment certificates (GICs)
GICs, which are only available in Canada, offer a secure way to invest your money and earn interest income. Like the name says, your money and the interest earned is guaranteed to return to you at the end of the term. GICs are typically offered at terms of between 30 days and five years, though longer terms of between seven and 10 years are also available.
Money market funds
Money market funds, while considered fixed income instruments, are mutual funds that invest in high-quality and highly liquid interest-paying securities, including short-term government bonds, T-Bills, and short-term debt issued by companies, called commercial papers.
These funds are meant to offer investors a better return than a savings account at very low risk, as well as the ability to access their funds at any time. However, unlike other types of fixed income, you can’t lock in a specific interest rate with money market funds: their distribution yields fluctuate depending on the interest rate environment.
Key elements of fixed income
All fixed income securities share two characteristics: they are structured to provide contractual interest payments to investors, and they have a fixed term, or maturity date.
How much interest an investment will pay — its yield — depends on the broader interest rate environment and the credit quality of the issuer. In higher rate environments, financial institutions that offer GICs will increase the rates offered for those products, and new-issue bonds will pay higher interest. (The reverse occurs in falling rate environments.)
For bonds specifically, the interest rate will vary depending on its issuer. Bonds issued by the Government of Canada and U.S. Treasury pay some of the lowest interest rates on the market because both institutions are so stable that these bonds are considered virtually risk-free.
Meanwhile, corporations with lower credit scores will have to offer much higher interest payments to incentivize investors — but these bonds come with a much greater risk of the issuer defaulting on their debt.
The maturity date is the point at which the investor’s principal is paid back and the fixed income instrument ceases to exist. That date is a significant factor in the investment’s risk and return profile. Fixed income with longer terms — such as bonds with maturity dates of 10 to 30 years — will typically offer higher interest rates than short-term investments, in order to entice investors to lock up their money for longer. But their long duration means these investments are more exposed to factors that could negatively impact their value, such as rising inflation or interest rate changes.
Money market funds are slightly different: the underlying investments in the fund do have maturity dates, but the fund manager continually invests in newly issued short-term debt so the fund itself does not mature and roll up.
Benefits of fixed income
If stocks are the flashy main character of a retail investor’s portfolio, fixed income is the low-key but reliable supporting player. These investments appeal to investors for a handful of reasons:
Safety: Fixed income products generate lower returns than stocks, but they are also more secure, meaning investors can likely expect to receive their initial investment back at the maturity date, along with the promised interest. High-quality fixed income, in particular, provides a high degree of safety for investors. Government bonds and investment grade credit are generally less risky, but high-yield bonds may have a similar risk profile, with different payoff characteristics.
Income generation and capital preservation: Fixed income products mostly pay out interest semi-annually or annually, though some pay monthly or quarterly. For investors who need regular and predictable income — such as retirees — this is a major benefit.
Diversification: The lower-volatility experience of most fixed income products, and their contractual interest payments, often offer a smoother investing experience. Fixed income products themselves also vary significantly, and holding investments with a mix of duration, quality, and risk levels adds diversification benefits to a portfolio.
Risks of fixed income
While fixed income investments are generally lower-risk assets, they still are exposed to some market forces that can influence their value.
Interest rate changes: When interest rates increase, the price, or face value, of existing fixed income products will drop. That’s because their income stream is no longer competitive relative to the new going rate for debt instruments. Interest rate changes have a greater impact on longer-term fixed income products, because investors who own them would have to hang onto a sub-par income stream for longer. Investors can hedge against interest rate risk by holding fixed income products with a range of maturity dates, a strategy that’s called laddering. As the shorter-term bonds mature, investors reinvest the proceeds into newly issued bonds of the same duration. It’s also important to note that the price of a fixed income investment is a reflection of what the market is willing to pay for a stream of income. Any decrease in that price is only a loss on paper if you plan to hold the product to maturity.
Inflation: This risk applies to most fixed income, with the exception of inflation-linked or real return bonds such as Treasury Inflation-Protected Securities issued by the U.S. Treasury. Because the amount of interest paid on a fixed income investment is, well, fixed, its purchasing power can diminish if inflation increases significantly. This is another risk that longer-term fixed income products are particularly exposed to.
Credit Risk: When expectations for the economy take a downward turn, the price of bonds with credit risk tends to drop as investors account for an increased likelihood that borrowers will have trouble making their payments. Issuers with relatively low credit risk — e.g., provincial governments or large, profitable corporations — may only see a minor decline, while more risky borrowers, such as bonds in the “high yield” market, can see significant declines — sometimes even comparable to stocks.
Liquidity: Liquidity risk is the risk that you may not be able to quickly buy or sell the asset. While fixed income is largely a liquid asset class, some bonds trade less frequently, and you may also have a harder time selling fixed income from an issuer whose credit has just been downgraded.
Taxation: Bond interest payments are treated as ordinary income for tax purposes. That means that when you hold a bond or bond fund outside of registered accounts such as an RRSP or TFSA, you must add the full value of interest payments to your taxable income and pay tax at your marginal rate. That’s relatively inefficient compared to equities, where returns often come at least partly from capital gains or tax-preferred dividends.
In Canada, GICs come with liquidity risk: many are non-redeemable, meaning you can’t pull your money before the maturity date without a financial penalty. In exchange, these products offer higher interest rates. Redeemable GICs allow you to access your funds before the maturity date if necessary, but they pay a lower interest amount.
