You decided it’s finally time to dip your toes into investing. You began researching the different investment options available to you, and on your journey to learning more, you discovered something called a fixed income investment. “What exactly is that?” you wondered. “Is it a good option for me?”
Below, we’ve broken down everything you need to know about fixed income investments. We’ll take a look at the different types of fixed income investments, and offer advice for how to discern whether this type of investment is fitting for you.
What Are Fixed Income Investments?
A fixed income investment works like this: A borrower (such as the U.S. government, a large municipality, or an investment-grade company) agrees to pay you a fixed amount of interest over a set period of time in exchange for you lending them money. In short, you’re lending an entity money and you’re getting a guaranteed rate on interest in return. You’ll also get your principal back at maturity.
For example, let’s say you purchase a $10,000 two-year U.S. Treasury bond with a coupon payment of 2.5% interest paid semi-annually. You would receive $125 in income twice a year for two years, as well as the $10,000 principal when the bond matures in two years.
Fixed income investments include everything from bonds, bank accounts, and certificates of deposit to municipal bonds, treasury bonds, and mortgage-backed securities.
Fixed income investments are a great addition to a diversified portfolio. They provide stability and allow you to have a set rate of return for part of your portfolio that is immune to volatility in the stock market.
Types of Fixed Income Investments
Here is a handful of common fixed income investments you might be familiar with:
- Money market accounts
- Money market funds
- Certificates of deposit (CDs)
- U.S. Treasury bonds (also called T-Bills)
- U.S. government agency bonds
- Municipal bonds
- Mortgage-backed securities
- Corporate bonds
- Bond mutual funds
- Bond ETFs
When it comes to finding the right fixed income investment for you, one of the first things you’ll want to look at is the term of the investment. Below, we’ve explored some common short-term and long-term options.
Short-Term Fixed Income Investments
Short-term fixed income investments like the ones below typically fall within the 6- to 12-month range. Short-term investments are ideal for those who have a specific goal in the near future for how they’d like to use their earnings.
Money Market Deposit Accounts
A money market deposit account is a type of savings account that has slightly better returns than a traditional savings account.
- They are FDIC-insured. Money markets are insured for up to $250,000 by the Federal Deposit Insurance Corporation (FDIC), which offers an extra level of protection.
- Interest rates are safe. (They are determined by the bank and the amount of the deposit.)
- You have check-writing capabilities and debit access, though both are limited.
- Although your money is accessible, there are a limited number of withdrawals per statement cycle (typically six).
- Money markets typically have lower interest rates — and therefore smaller returns — due to same-day availability of funds.
Money Market Mutual Funds
Money market mutual funds, also called money market funds, are mutual funds that only invest in highly liquid options with a short-term maturity. Typically, this maturity is less than 13 months.
- They have a higher rate of return than most bank savings accounts and money market deposit accounts.
- Money market funds offer a higher yield and lower risk than most other fixed income securities because they invest in high credit quality investments (such as U.S. Treasury bills) that are mandated by the Securities and Exchange Commission (SEC).
- Money market mutual funds are not FDIC-insured, as they are sold by investment companies. This adds a layer of risk.
- Your return is fixed and dependent on interest rates, which means it moves independent of inflation.
- There are expenses and fees associated with money market funds.
Certificate of Deposit
Certificates of Deposit (CDs) are savings accounts in which your money earns returns by sitting in the account for a set period of time. CDs have a fixed interest rate and a fixed maturity date. There are both short-term and long-term CDs, which can be anywhere from three months to five years. Short-term CDs typically range from three to 12 months.
- There is relatively low risk on CDs.
- They offer higher returns than money market accounts.
- CDs are FDIC-insured, which means your principal investment is protected.
- The fixed interest rate and fixed period of time can make this a good option if you’re planning for a specific goal.
- If you need to access the funds before the maturity date, you will be hit with an early withdrawal penalty.
- If interest rates increase while you are invested in a CD, you could be locked into lower rates than the market is offering to date.
Long-Term Fixed Income Investments
If you’re starting an investment portfolio or are primarily interested in focusing on long-term investment goals, you might want to consider long-term fixed income investments and bonds. Below are a handful of options to consider.
A bond ETF, or a bond exchange-traded fund, is a portfolio of bond funds that is traded on an exchange. Bond funds are a safer form of investing than stocks. They provide diversification exposure to the bond market without the cost of investing in individual bonds.
- There are numerous investment options, so you can select specific bond ETFs that align with your financial goals.
- They’re liquid. ETFs that are traded during market hours can be bought and sold easily.
- Income dividends are paid monthly, which is more frequent than individual bonds.
- There is price transparency. The value of ETFs is updated during trading hours.
- There is also holdings transparency. ETFs disclose security holdings on a daily basis.
- With bond ETFs, you risk potentially losing part of your principal due to fluctuations in the maturity date.
- There are expenses and fees associated with ETFs.
Bond Mutual Funds
A bond mutual fund is a mutual fund that only invests in bonds. A bond mutual fund is managed by a professional money management team who will buy and sell bonds according to market activity.
- Bond mutual funds allow you to diversify your portfolio without having to buy individual funds.
- If you’re new to investing, you will be guided by an experienced professional.
- You could risk losing part of your principal investment on longer-duration bond funds.
- Your income could vary from month to month because the underlying bonds could mature.
- The risk with bond mutual funds is higher than owning individual bonds because the portfolio manager is likely buying and selling bonds prior to their maturity.
- The expense and fees associated with bond mutual funds can be high.
Municipal Bond Funds
Municipal bonds are bonds that are issued by states, cities, counties, and towns. A municipal bond fund is a fund that invests in these bonds. They allow you to have a diversified portfolio without having to invest in individual municipal bonds.
- Municipal bonds are exempt from federal income tax.
- They typically yield lower, but steadier, returns.
- You could risk losing part of your principal if interest rates increase dramatically.
- Although extremely rare, the possibility of default exists. (This is more common in revenue bonds than general obligation bonds.)
The Benefits of Fixed Income Investments
There are several benefits to including fixed income investments in your portfolio. These are the three primary benefits of fixed income investments:
- You’re preserving your capital. Because the principal is repaid at a specified date or maturity, the interest rate is often higher than the short-term savings rate.
- You’ll have predictable income. Fixed income investments are great for consumers who like predictability and stability, as they are paid out on a set schedule that is typically quarterly, semi-annually, or annually.
- You’re diversifying your portfolio. Fixed income investments allow you to make consistent returns while navigating the inherent highs and lows of the investing in the stock market.
The Risks of Fixed Income Investments
There are a handful of risks when it comes to fixed income investments. Below are some of the most common risks and downsides.
Risks related to fixed-income investments:
- You’re giving up returns for stability. Choosing fixed income investments means that you’re opting for stability in exchange for the sometimes high returns that come with other types of investments.
- There is an inflation risk. The amount of interest you receive on fixed income investments is independent of inflation, which could affect your earnings if you select a longer-term option. For example, if inflation rises by 2%, and you are locked into a CD paying 3%, your real return will fall to 1%.
- There is an interest rate risk. If interest rates rise and you are locked into fixed rate investments with a time component, the real value of your return will go down. For example, if you are locked into a CD paying 3% today, and due to rising interest rates, the going rate for a CD is 4.5%, you’re losing 1.5% in potential return.
Risks specific to fixed-income bonds:
- There is additional interest rate risk. Bonds move inversely with interest rates so when interest rates rise, bond prices go down. This means your principal value could be affected if you try to sell your bond or get out of the investment before the stated maturity when rates are rising.
- There is a credit risk. There is always the risk that a bond’s issuer will not be able to make the interest payments or the principal payment come maturity.
- The bond could be called. Some bonds have a call provision, which allows the issuer to redeem (or call) the bond and pay out the principal before the maturity date.
Who Will Benefit From Fixed Income Investing? Who Won’t?
Fixed income investments should be included in your savings strategy if you’re looking to create a diversified portfolio. They’re particularly beneficial if you have at least six to nine months of living expenses saved and no high-interest debt, such as credit card debt.
If you’re looking to put away money for defined goals in the immediate future, say one to three years, they can also be beneficial. For example, let’s say you know you’ll be purchasing a home in a few years. You could consider CDs or U.S. Treasury bills, as they’ll both give you steady returns as you save.
Fixed income securities are also a common option for people who are retired or are nearing retirement and are looking for a small, steady source of income each month. They can create a consistent cash flow that can assist in one’s living expenses.
If you don’t have at least six to nine months of living expenses saved, you might want to think twice before considering fixed income investments. If you need access to cash due to an unexpected expense, your funds could be tied up. If your money is in a CD, for example, as opposed to a money market account, you could have to pay a penalty to pull out the money before the maturity date.
Fixed income investments are also not a good idea for those with significant high-interest credit card debt. Your money will be better spent paying off that debt, as interest rates on credit card debt are higher than any potential returns you’ll receive from fixed income investments.
Ask Yourself These Questions Before Getting Started
If you’ve decided you’d like to explore fixed income investing, you can get started by asking yourself a few questions:
- What is the time frame I’m working with? When will I potentially need the money?
- What is my risk tolerance? Am I risk-prone or risk-averse?
- What types of fees are associated with the investments I’m considering? Am I comfortable paying them, or should I keep looking around?
When it comes to investing, it’s important to have a balanced and diversified portfolio, and fixed income investments can be a great addition to one’s portfolio. Research and compare the different types of fixed income investments out there to find out which ones are the best fit for you.