What Is Fixed Income Investing?
Fixed income investing refers to a category of investments that provide returns in the form of regular, predetermined interest payments and the eventual return of principal at maturity. The term "fixed income" comes from the fact that these securities typically pay a fixed rate of interest, giving investors a predictable stream of income.
Fixed income securities are essentially loans made by investors to borrowers, which can be governments, municipalities, or corporations. In exchange for lending their money, investors receive periodic interest payments (called coupons) and get their original investment back when the security matures. This predictability makes fixed income a cornerstone of conservative investment portfolios and an important tool for managing risk.
"Fixed income is the ballast that keeps your portfolio steady when equity markets are stormy."
Types of Fixed Income Securities
The fixed income market encompasses a wide range of instruments, each with its own risk profile, return potential, and tax treatment. Understanding these differences helps investors choose the right securities for their needs.
Government Bonds
Government bonds are debt securities issued by national governments to fund public spending. In the United States, these include Treasury bills (short-term), Treasury notes (medium-term), and Treasury bonds (long-term). Because they are backed by the full faith and credit of the issuing government, U.S. Treasuries are considered among the safest investments in the world. Other government securities include Treasury Inflation-Protected Securities (TIPS), which adjust their principal based on changes in the Consumer Price Index, protecting investors against inflation. For a deeper look at bond pricing, yields, and strategies like bond laddering, see our Bond Investment Basics guide.
Corporate Bonds
Corporate bonds are issued by companies to raise capital for operations, expansion, acquisitions, or refinancing existing debt. They typically offer higher yields than government bonds to compensate investors for the additional credit risk. Corporate bonds are categorized by credit quality:
- Investment-grade bonds: Rated BBB/Baa or higher by major rating agencies, these are issued by financially stable companies and carry lower risk of default.
- High-yield bonds (junk bonds): Rated below BBB/Baa, these offer higher interest rates to compensate for greater default risk. They can provide attractive returns but require careful credit analysis.
Municipal Bonds
Municipal bonds (munis) are issued by state and local governments to fund public projects like schools, roads, and hospitals. Their primary advantage is tax treatment: interest from most municipal bonds is exempt from federal income tax, and may also be exempt from state and local taxes if you live in the issuing state. This tax advantage can make munis particularly attractive for investors in higher tax brackets.
Certificates of Deposit (CDs)
A certificate of deposit is a time deposit offered by banks that pays a fixed interest rate for a specified term, ranging from a few months to several years. CDs are insured by the FDIC (up to $250,000 per depositor per bank), making them one of the safest fixed income options available. The trade-off is that withdrawing money before the CD matures typically incurs an early withdrawal penalty.
Money Market Instruments
Money market securities are short-term debt instruments with maturities of one year or less. They include Treasury bills, commercial paper (short-term corporate debt), and banker's acceptances. These instruments prioritize capital preservation and liquidity over high returns. Money market mutual funds invest in a diversified portfolio of these instruments and aim to maintain a stable share price of $1.
Agency Bonds
Agency bonds are issued by government-sponsored enterprises (GSEs) such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. While not directly guaranteed by the U.S. government, they carry an implicit government backing and typically offer slightly higher yields than Treasuries. These bonds finance activities in sectors the government considers important, particularly housing.
How Fixed Income Works
Understanding the mechanics of fixed income securities is essential for making informed investment decisions.
Coupon Payments
Most fixed income securities pay interest at regular intervals, typically semiannually. The coupon rate is the annual interest rate expressed as a percentage of the bond's face value (par value). For example, a bond with a $1,000 face value and a 5% coupon rate pays $50 per year, usually in two $25 payments. Some securities, like zero-coupon bonds, do not make periodic interest payments. Instead, they are sold at a discount to face value and pay the full face value at maturity.
Maturity
The maturity date is when the issuer repays the principal amount to the investor. Fixed income securities are often categorized by their time to maturity:
- Short-term: 1 to 3 years
- Intermediate-term: 3 to 10 years
- Long-term: More than 10 years
Generally, longer maturities carry more risk and offer higher yields to compensate investors for the extended commitment of their capital.
Yield and Interest Rates
Understanding yield is crucial for comparing different fixed income investments and assessing their true return potential.
Current Yield vs. Yield to Maturity
Current yield is calculated by dividing the annual coupon payment by the bond's current market price. It gives a quick snapshot of the income return but does not account for capital gains or losses at maturity. Yield to maturity (YTM) is a more comprehensive measure that considers all future coupon payments, the difference between the purchase price and face value, and the time remaining until maturity. YTM represents the total annualized return if the bond is held to maturity.
The Relationship Between Prices and Yields
Bond prices and yields move in opposite directions. When interest rates in the economy rise, newly issued bonds offer higher coupon rates, making existing bonds with lower rates less attractive. To compete, the market price of existing bonds falls, which effectively raises their yield. Conversely, when interest rates fall, existing bonds with higher coupons become more valuable, pushing their prices up and yields down. This inverse relationship is a fundamental concept in fixed income investing.
Credit Ratings and Risk
Credit ratings assess the likelihood that a bond issuer will meet its financial obligations. The three major rating agencies are Standard & Poor's (S&P), Moody's, and Fitch. Their ratings help investors gauge default risk:
| Rating Category | S&P / Fitch | Moody's | Risk Level |
|---|---|---|---|
| Highest Quality | AAA | Aaa | Minimal |
| High Quality | AA | Aa | Very Low |
| Upper Medium | A | A | Low |
| Medium | BBB | Baa | Moderate |
| Speculative | BB and below | Ba and below | High |
Bonds rated BBB/Baa and above are considered investment grade, while those rated below are considered speculative or high-yield. Higher-rated bonds offer lower yields because they carry less risk, while lower-rated bonds must offer higher yields to attract investors willing to accept greater default risk.
Risks of Fixed Income Investing
While fixed income securities are generally considered less risky than stocks, they are not without risk. Understanding these risks helps investors make better decisions.
- Interest Rate Risk: The risk that rising interest rates will cause bond prices to fall. Longer-duration bonds are more sensitive to rate changes.
- Credit Risk (Default Risk): The risk that the issuer cannot make interest payments or repay principal. This is higher for corporate and high-yield bonds.
- Inflation Risk: The risk that inflation erodes the purchasing power of fixed coupon payments over time. A bond paying 3% while inflation runs at 4% delivers a negative real return.
- Reinvestment Risk: The risk that when coupons or principal are received, prevailing interest rates are lower, meaning proceeds must be reinvested at reduced rates.
- Liquidity Risk: The risk that a bond cannot be sold quickly at a fair price. This is more common with municipal bonds and smaller corporate issues.
- Call Risk: Some bonds are callable, meaning the issuer can repay them before maturity, typically when interest rates fall. This forces investors to reinvest at lower rates.
Fixed Income in Your Portfolio
Fixed income securities play several important roles in a diversified investment portfolio.
Income Generation
Regular coupon payments provide a reliable stream of income, which is especially valuable for retirees and income-focused investors. Unlike stock dividends, which can be cut or eliminated, bond interest payments are contractual obligations of the issuer.
Capital Preservation
High-quality fixed income securities, particularly government bonds and investment-grade corporate bonds, help protect capital. While their prices fluctuate, holding to maturity ensures the return of face value (assuming no default).
Diversification
Bonds often behave differently from stocks. During stock market downturns, investors frequently shift money into government bonds, pushing bond prices up. This negative correlation can smooth out overall portfolio volatility and reduce risk.
How Much Fixed Income Should You Hold?
The appropriate allocation depends on your age, risk tolerance, income needs, and financial goals. A common guideline suggests holding a bond percentage roughly equal to your age (for example, a 40-year-old might hold 40% bonds). However, this is just a starting point. Investors closer to retirement or with lower risk tolerance may want a higher allocation, while younger investors focused on growth may prefer less.
Fixed Income ETFs and Mutual Funds
For most individual investors, fixed income ETFs and mutual funds offer the most practical way to invest in bonds. These funds pool money from many investors to purchase a diversified portfolio of fixed income securities, providing several advantages over buying individual bonds:
- Diversification: A single fund can hold hundreds or thousands of bonds, spreading credit risk across many issuers.
- Accessibility: You can invest with relatively small amounts, unlike individual bonds which often have high minimum purchases.
- Professional management: Fund managers handle security selection, trading, and reinvestment of income.
- Liquidity: ETFs trade throughout the day on exchanges, and mutual fund shares can be redeemed daily at net asset value.
Popular fixed income fund categories include total bond market funds, short-term bond funds, intermediate-term bond funds, high-yield bond funds, municipal bond funds, and Treasury-focused funds.
