Fixed-income investing means you loan money to a company, municipality, or the government. In return for the money contributed, they issue a bond, kind of like an IOU. The bonds have an interest rate attached to them, and you earn income by interest paid as a dividend over a fixed period of time or by selling the bond for more than you paid. If you hold the bond to maturity, the borrower is supposed to pay the amount borrowed.
The idea behind fixed-income investing
Fixed-income investing involves putting funds in low-risk assets that have a fixed stream of income. This investing strategy aims to try and mitigate market risk while still generating a return.
· Bonds
The issuers of bonds are known as the borrowers. The borrower then pays the investor a fixed interest rate (the coupon rate) for a specified period of time.
· Money-market funds
A type of mutual fund offered by banks and credit unions that invests in low-risk, short-term debt securities, for example, Treasury bills. If the bank is FDIC insured, your money market account is insured up to $250,000. Credit unions have their own insurance fund, the National Credit Union Administration (NCUA), which is also secured up to $250,000.
· Certificates of deposit (CDs)
A CD is a low-risk savings account offered by credit unions and banks that pays interest for a specified period of time. Typically, you agree to keep your money in the CD and not take a withdrawal until the CD matures. If you withdraw your money early, you may have to pay a penalty fee to the bank. If you purchase a CD at an FDIC-insured bank, your money is also insured up to $250,000. If you purchase through a credit union, your CD is insured by the NCUA, which is safeguards up to $250,000.
· Bond exchange-traded funds (ETFs)
This type of security involves pooling your money with other investors, which is then invested into different bonds. Units of a bond ETF can be traded in real-time on exchanges during market hours. Bond ETFs pay interest to investors through a dividend. These dividends get treated as capital gains or income for tax purposes.
· Bond mutual funds
Similar to a bond ETF, a bond mutual fund is a pool of capital from investors, and the fund is professionally managed, and the capital allocated to different securities.
Risks of fixed-income investing
Like any investment, there are risks associated that you should take into consideration. Some of these include:
· Credit risk
This generally becomes a factor depending on the type of security you invest in, for example, bond funds that invest in lower-quality, high-yield, or non-investment grade bonds. As an investor, you want to do your research and understand a fund’s credit quality guidelines.
· Liquidity risk
When a security is liquid, you can buy or sell investments quickly and for a price close to the asset's actual value. Liquidity risk is when you may not be able to buy or sell an investment as soon as you would like. Regarding fixed income, liquidity risk is higher for bonds with a lower credit rating, recently downgraded bonds, or bonds sold by an infrequent issuer.
· Interest rate risk
This risk will primarily come into play if you buy bonds on the secondary market, where prices can be higher or lower than the face value depending on market conditions and the economic landscape. A change in interest rate can dramatically impact bond prices.
· Inflation risk
Inflation risk is the possibility that inflation rises and lowers the purchasing power of your income. If your goal is to live off your bond income, this type of risk could be concerning.
· Call risk
Callable bonds allow the issuer to call or repay the bond earlier than the maturity date. Bond issuers can save money by repaying callable bonds and issuing new bonds at lower interest rates when interest rates drop. If you are a bondholder and this occurs, your interest payments end, and you receive your principal.
· Prepayment risk
Prepayment risk involves the risk that the security issuer will repay the principal before the bond reaches maturity. Doing so alters the payment schedule of the bond. A typical example of this occurs with mortgage-backed bonds when a drop in the market makes refinancing very attractive for homeowners.
Consider consulting a financial professional
Consider consulting your financial professional to help you identify your risk tolerance and determine if fixed-income investing could work for you and your financial strategy and goals.
Sources: Fixed Income Risks - Overview, Breakdown, Why Matters (corporatefinanceinstitute.com) What is a certificate of deposit (CD)? | Consumer Financial Protection Bureau (consumerfinance.gov) What Are Bond Funds? - Fidelity Risks of Fixed Income Investing | Fidelity Institutional
Important Disclosures:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
An investment in Exchange Traded Funds (ETF), structured as a mutual fund or unit investment trust, involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks such as not diversified, price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. An increase in interest rates may cause the price of bonds and bond mutual funds to decline.
CDs are FDIC Insured and offer a fixed rate of return if held to maturity.
An investment in the Money Market Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the Fund.
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