Fixed-Income Investments (2024)

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• Fixed-income investing involves assets that generate a stable returns, usually with set interest payments or dividends.
• The most common types include bonds, annuities, and certificates of deposit.
• Though relatively safe, fixed-income assets are subject to inflation risk and don't offer much capital appreciation.

With a conservative investment strategy, the name of the game is to preserve a portfolio's wealth and generate income through low-risk assets. The aim is to provide a steady cash stream, like a regular paycheck.

People nearing the end of their careers who are looking to cash in, rather than grow their portfolios, often favor this approach and lean more heavily toward fixed-income investing strategies. It's one of the safest ways to invest, moving away from the volatile highs and lows of the equity market in favor of other assets, usually government or corporate bonds.

Understanding fixed-income investments

Definition and overview

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.

How fixed-income investments work

Income investing — and fixed-income investing in particular — is the opposite of growth investing. Assets that generate steady money tend not to be the type that will appreciate much in value. 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

Government bonds

When people think of fixed-income investments, bonds are usually the first thing that comes to mind. Government bonds, like U.S. Treasuries, are the most common.

In most cases, you can think of these investments like loans: 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 interest added 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 30 years. Treasury bills can even mature in less than a year.

Let's say you purchase a fixed-rate T-bond for $1,000 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 that has issued corporate bonds goes bankrupt, a lender may not get back their entire initial investment.

This has never happened with U.S. Treasuries, which is why they're considered virtually risk-free. They are 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 track financially 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.

Corporate bonds

Corporate bonds are similar to government bonds, except they are issued by businesses to fund business activities. Corporate bonds frequently pay higher yields than their government counterparts.

However, these securities may also present investors with a greater level of risk. For example, if you purchase one of these bonds and then the company that issued it declares bankruptcy, it could render your investment worthless.

Municipal bonds

Municipal bonds can be issued by cities, states, counties, or other government organizations to help them finance public projects like schools or roads. Usually, the interest paid by these bonds is exempt from federal taxes. In some cases, these bonds may be free of state and local taxes too.

Certificates of deposit (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.

An added benefit is that any money you put into a CD is covered by the The Federal Deposit Insurance Corporation (FDIC), which insures the deposits of everyday consumers.

Treasury inflation-protected securities (TIPS)

Treasury inflation-protected securities (TIPS) are securities whose principal and interest both respond to changes in the price level. In buying one of these, you are basically lending the U.S. federal government money, and then you receive an interest payment once every six months.

The interest rate paid is proportional to the size of the principal, which is adjusted for inflation based on the Consumer Price Index for Urban Consumers (CPI-U).

Benefits of fixed-income investments

Steady income stream

One of the benefits of fixed-income investments is that they provide you with a series (or stream) of regular payments. This can be highly advantageous for those who want to live off their investments, for example retirees.

It can also be useful for those who want to supplement any other income streams they have currently.

Lower risk compared to equities

Fixed-income investments frequently have less downside risk than stocks, meaning that if you buy them, you are less at risk of losing your principal, in other words the money you put in originally. Past that, they offer regular payments, something that many stocks do not.

Treasury bonds are issued by the U.S. federal government, meaning that they are backed by its full faith and confidence. At the time of this writing, the U.S. government has been around for almost 250 years, longer than many companies that also issue securities.

Diversification

Fixed-income investments can be a valuable tool in achieving diversification. You can combine them with other securities, for example stocks, to create a portfolio.

Another possibility is using securities like bond mutual funds to quickly gain exposure to a wide range of fixed-income investments.

Capital preservation

One major benefit of fixed-income investments is that they have less downside risk than stocks, meaning they can be a more effective tool for safeguarding the value of whatever capital you invest. Fixed-income securities can be issued by entities that seem very likely to return your investment, for example the U.S. federal government.

Strategies for investing in fixed income

Laddering strategy

Laddering, one of the better-known fixed-income investment strategies, involves buying bonds with different expiration dates. Basically, this approach is the exact opposite of trying to time the markets. By doing this, you can help manage the risk associated with interest rate fluctuations, which can have an impact on the value of your bonds.

Barbell strategy

A barbell strategy involves purchasing both short-term and long-term bonds. This strategy provides a few different benefits, including diversification. The returns provided by short-term and long-term bonds generally have a negative correlation.

Another benefit of this approach is that it grants you exposure to long-term bonds, which can provide compelling returns. At the same time, the strategy helps you manage some of the risk associated with these securities by giving you exposure to short-term bonds.

Risks associated with fixed-income investments

Interest rate risk

Interest rates and bond prices frequently move in opposite directions. In other words, if interest rates push higher, it could place downward pressure on the value of your fixed-rate bonds. On the other hand, if interest rates decline, it could serve as a boon to your fixed-rate bonds, placing upward pressure on their prices.

Credit risk

Credit risk is the risk that the party issuing a bond or other fixed-income instrument will not make good on its obligations. For example, a company that is struggling financially might fail to make good on its bond payments. In addition, some countries have failed to make payments to holders of sovereign debt in a timely manner.

Inflation risk

Inflation risk is the risk that an increase in the price level will affect bonds either by reducing the purchasing power of their payments or alternatively lowering the price by placing upward pressure on interest rates and therefore downward pressure on bond prices.

How to choose the right fixed-income investment

Assessing risk tolerance

Before making any investment decisions, one of the most important steps is evaluating your tolerance for risk. How much volatility are you willing to tolerate in your portfolio? Are you willing to incur sharp losses in your portfolio in the short-term? How long can you tie up your money in investments?

Evaluating investment goals

What are your objectives? Are you saving for retirement? Are you putting money away for a college fund? How many years in the future would you like to reach your goal?

The journey of a thousand miles starts with the first step. In order to know what to do next, you need to determine your objectives.

Diversifying your portfolio

One benefit of fixed-income investments is that they can help you diversify your portfolio. They could be an excellent complement to stocks, for example.

The idea behind diversification is putting your money into many different asset types so that if one asset type (for example, bonds or stocks) loses significant value, the other components of your portfolio won't suffer substantial losses.

There are many different types you could potentially incorporate into your portfolio to achieve diversification, for example real estate and commodities like gold, silver, and oil.