Summary List Placement
Fixed-income investing is a strategy in which the name of the game is income. It aims to provide investors with a steady cash stream, like a regular paycheck. It's a conservative approach — in fact, it's often considered one the safest ways to invest, avoiding the risky equities market — and the volatile highs and lows of stock trading — in favor of other vehicles, usually government or corporate bonds (debt securities). For these reasons, fixed-income investing is often favored by people towards the end of their careers, who are looking to cash in, rather than to grow, their portfolios. But it can benefit anyone who's in need of extra money, or who wants to diversify their investment mix. What is fixed-income investing? In the simplest terms, fixed-income investments are those that provide a regular and often predetermined payout, generally in the form of interest or dividend payments. They are fixed in the sense that they don't fluctuate, either in the amount or the timing of their payments. Income investing — and fixed-income investing in particular — is the opposite of growth investing. The sort of assets that generate steady money tend not to be the type that'll appreciate in value much. On the other hand, they (usually) won't go down; they offer financial security, especially if you hold onto them. It's like the difference between placing a standing order to buy a dozen roses each year and planting a rose bush. With the former, you know that you're getting 12 roses — no more, but no less. With the latter, you may get many dozens of roses, but a harsh winter could kill your plant, leaving you with no blooms at all. Types of fixed-income investments There are several types of fixed-income investments. Their payouts vary, but the rates all tend to be higher than those of the average savings account. Here are the most common: 1. Bonds When people think of fixed-income investments, bonds are usually the first thing that comes to mind. Government bonds, like US Treasuries, are the most common. Other types include corporate bonds and municipal bonds. In most cases, you can think of these sorts of fixed-income investments like a loan: The borrower is the bond's issuer, and the investor, rather than a financial institution, is the lender. A bond has a set lifespan; when it eventually matures, the investor gets back what they initially paid along with added interest along the way. With short-term bonds, that could happen in one to four years. With long-term bonds, it could take as long as 10 to 20 years. Treasury bills can even mature in less than a year. Let's say you purchase a fixed-rate T-bond for $1000 with an interest rate of 1.25%. If the bond matures in 30 years, you will receive $12.50 every year (or more realistically, $6.25 every six months because T-bonds have semiannual coupon payments). Overall, you can expect to make $375 on top of your initial investment. Of course, not all bonds make it to maturity. For example, if a company trading corporate bonds goes bankrupt, a lender may not get back their entire initial investment. This has never happened with US Treasuries, which is why they're considered virtually risk-free. Also relatively safe: highly rated, or investment-grade, corporate bonds — usually issued by large, stable corporations. When it comes to risk, the issuer's creditworthiness is important. But so is the bond's lifespan —that is, how long it takes to mature. Overall, long-term bonds — particularly corporate long-term bonds — provide the highest returns, but are also considered the riskiest. This is because they're most vulnerable to interest rate hikes, which can lessen the value of the bond if an investor is trying to sell it before it reaches maturity. There's also a lot more time for a corporation to steer off financial track and default on payments, including the eventual return of your initial investment. Short-term bonds, on the other hand, are less vulnerable to interest rate swings, and much easier to hold until maturity. But they provide the smallest returns. 2. Bond ETFs and Bond Mutual Funds Rather than purchasing an individual bond, an investor may wish to invest in a bond ETF (exchange-traded fund) or bond mutual funds. In both these cases, you're buying into a portfolio of bonds. This type of diversification leads to a more stable investment, and oftentimes, you'll see bond mutual funds tied into 401(k) retirement plans. Bond ETFs and mutual funds have a number of different strategies. Some of them mix portfolios of long- and short-term bonds. Others mix low-risk US Treasuries with high- risk but high-yield corporate bonds (aka junk bonds). Like buying a single bond, the average ETF or bond fund pays regular — sometimes even monthly — income. Bond mutual funds' payout is more likely to vary since their portfolios change more frequently. 3. Fixed annuities A fixed annuity is actually a sort of contract with an insurance company. The agreement calls for the company to pay the same sum at regular intervals for a set period of time. Since it functions sort of like a salary, annuities are very popular among people who have retired or are nearing retirement. When buying an annuity, investors will generally invest a lump sum with the insurer. This money is repaid to them, with interest, over time. Their habitual payments typically end with their death or the death of a beneficiary (i.e. spouse), depending on the annuity policy. The major downside is that if an investor dies before collecting the full amount of their annuity investment, that leftover money may be passed onto the company that sold it to them rather than their surviving family. 4. CDs Like bonds, certificates of deposit (CDs) offered by banks and credit unions are a slightly better-paying alternative to the average savings account. And they work in a similar way. You buy a CD by depositing a lump sum in an account at the financial institution. In layman's terms, you're giving them a loan. The CD earns interest for a set period of time — between six months and 10 years, depending on the CD. When the time's up, you'll get back your initial deposit. 5. Preferred Stocks Most forms of fixed-income investing don't give you equity, or ownership, in anything. Even corporate bonds function merely as a loan to the company. But preferred stock is sort of the best of both worlds — the prime features of both bonds and stock shares. Preferred stock are shares in a company. They offer regular dividends, which come from the company's profits, that are paid out in a fixed amount every quarter — like bond interest. The payment doesn't typically fluctuate the same way a common share dividend does, and it's usually higher, too. But since preferred shares are stocks, they do trade on the market, and they can appreciate in price — especially if the company does well. However, they don't grow as much as common shares do. Preferred stock is riskier than other fixed-income vehicles because it's tied to a company's success. If a company runs into serious financial trouble, it might have to suspend dividend payments — though preferred shareholders still get paid before common shareholders. There's also the risk that the company could recall (force a buyback of) its preferred shares — or convert them to common shares. Benefits of fixed-income investing Fixed-income investments are particularly secure because:
They provide steady interest throughout the investment's lifetime You've got a locked-in interest rate. Your principal is backed or guaranteed by the US government (T-bonds) or the FDIC (CDs). Unlike stockholders, fixed-income investors can become creditors during a bankruptcy, meaning all or a portion of their initial investment may be returned. Bonds are given grades by credit rating agencies, signifying their ability to repay, so investors can understand their risk before they buy.
Risks of fixed-income investing Though risk is limited with fixed-income investments, it still exists. Risks include:
Credit risk: an issuer defaulting on interest payments or paying back the principal at maturity. Inflation risk. If prices rise, it'll eat into the value of your fixed payments. Your initial investment may not have as much buying power when it is returned, either. Interest rate risk. You'll miss out on higher returns if interest rates rise and you're locked into a lower fixed rate.
The financial takeaway Along with investors requiring money, fixed-income investments are a great place to start for beginning investors. They don't always require the same intimate market knowledge as equities and they're much less volatile. For the same reason, they don't offer the highest returns — and no capital appreciation in the long term. But they can serve as a better alternative to a traditional savings account. Overall, a good portfolio diversification strategy will include some sort of fixed-interest investments, too. Related Coverage in Investing: What is diversification? A portfolio strategy that uses a variety of investments to limit risk Investment income is money earned by your financial assets or accounts, and understanding how it works can help maximize your profits Passive investing is a long-term wealth-building strategy all investors should know — here's how it works Bonds vs. CDs: The key differences and how to decide which income-producing option is better for you What are liquid assets? A guide to the investments that are easiest to cash in, and why they're importantJoin the conversation about this story »
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