Fixed-income investments, such as government and corporate bonds, can provide a steady, predictable source of income, often with lower risk than other investments. Along with stocks and stock mutual funds, fixed-income investments make up the backbone of a well-diversified investment portfolio.
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What are fixed income investments?
Fixed income investments are investments, typically bonds, that generate a predictable amount of income (usually via interest payments) for the investor. Preferred stocks or bank certificates of deposits are also fixed income investments.
A bond is a loan from the investor to a corporation or government. The borrower pays interest over time and repays the principal amount at the end of a predetermined period. Bonds may make interest payments monthly, quarterly or semi-annually.
- For example, if you buy a 10-year bond with a face value of $5,000 that pays 3% interest, you’ll earn $150 annually for 10 years.
- After 10 years, you’ll have earned $1,500 in interest, and the government or corporation will also repay you your original principal amount of $5,000.
Like other investments, bonds can be bought and sold, and their value can rise above or fall below what you originally paid for them. Selling a fixed-income investment for a profit is one way to make money, though it’s often the regular payments investors are after, not the capital gains.
Pros and cons of fixed-income investments
Pros
Steady source of income.
Diversification.
Cons
Default risk.
Interest rate risk.
Relatively low returns.
Benefits of fixed-income investments
Steady source of income
This is a big reason that fixed-income investments are a staple in many investment portfolios. A regular stream of income is extremely valuable for most investors.
Diversification
The goal of diversification is to reduce the volatility of your portfolio by spreading risk. This can be accomplished by investing in various companies from different sectors, for example, but fixed-income investments provide even more stability for one main reason: Bond prices typically rise when stock prices fall (and vice versa).
In general, advisors typically recommend increasing a portfolio's asset allocation in fixed-income investments as retirement approaches. Doing so can reduce the risk that market-based turmoil could an oversized bite from your portfolio at a bad time.
Risks of fixed-income investments
Bonds are often less risky than stocks, but they have a few risks worth considering.
Default risk
Default risk is the likelihood that the bond issuer will fail to make its interest payments on time or fail to repay its debt. You can learn about an issuer’s creditworthiness by checking its credit-quality ratings from agencies such as Moody’s Analytics or Standard & Poor’s.
- Investment-grade bonds are the least likely to default; they have credit ratings of BBB or above (Standard and Poor’s) or Baa and above (Moody’s).
- High-yield bonds (also known as junk bonds) have ratings below those thresholds, meaning they're more likely to default.
Investment-grade bond ratings | |||
Moody's | Standard & Poor's | Fitch | What the grade means |
Aaa. | AAA. | AAA. | Highest quality, minimal risk. |
Aa. | AA. | AA. | High quality, very low risk. |
A. | A. | A. | High/Medium quality, low credit risk. |
Baa. | BBB. | BBB. | Medium grade, moderate credit risk. |
Non-investment-grade bond ratings | |||
Moody's | Standard & Poor's | Fitch | What the grade means |
Ba. | BB. | BB. | Substantial credit risk. |
B. | B. | B. | High credit risk. |
Caa. | CCC. | CCC. | Low quality, very high credit risk. |
Ca. | CC. | CC. | In or near default, some prospect of recovery. |
C. | C. | C. | Moody's lowest rating, typically in default with little prospect of recovery. |
C. | D. | D. | In default, also used when bankruptcy has been filed. |
Interest rate risk
Interest rate risk is the risk that market interest rates will rise, causing the value of the bond to drop. Specifically, if overall interest rates rise, newly issued bonds—and their higher coupon rates—will become more attractive, lowering the market value of older bonds with lower coupon rates.
Conversely, if interest rates fall, newly issued bonds will offer lower coupon rates, making the older bonds — whose coupon rates look now look relatively high — more attractive.
» Learn more about how interest rate risk affects bonds.
Relatively low returns
Bonds may be less risky than stocks, but they often don’t offer investors the same level of investment returns. Typically, investors allocate more of their portfolio toward stocks early on, then gradually shift it to bonds as they near retirement. This strategy maximizes long-term growth while minimizing risk as retirement approaches. Even with diligent saving, an all-bond portfolio may not grow enough for retirement.
» Learn more about what a bond market crash is and how to prepare.
Types of fixed-income investments
There is a wide range of fixed-income investments. See the most common below.
Treasury securities
Treasurys are bonds issued and backed by the U.S. government. They make up the largest portion of the U.S. fixed-income market.
Treasurys come in three forms: notes, bills and bonds. The biggest difference among these three is how long it takes for each one to reach maturity, as noted below:
The risk of the U.S. government defaulting on its bonds is virtually nonexistent, which secures bonds' status as a relatively safe long-term investment with consistent returns.
Municipal bonds
State and local governments issue municipal bonds.
Generally, interest income from municipal bonds is free from federal and state taxes (although this can vary by state). However, municipal bonds typically provide lower yields than other types of bonds. They are often recommended for investors in high tax brackets.
Municipal bonds are generally low risk, as the issuing cities and states can always introduce new taxes to generate the money to repay bondholders.
Corporate bonds
Corporate bonds are bonds from companies. Highly-rated, creditworthy companies are the least likely to default on their debt, making their bonds stronger candidates for reliable fixed-income vehicles.
High-yield bonds
These “junk bonds” are fixed-income securities that fall not investment-grade. However, they tend to offer higher interest payments in return for taking that extra risk.
Bond funds
Bond funds pool several different bonds into a single basket, allowing investors to add even more diversification to their portfolios with a single investment.
Fixed-income taxes
Taxes on fixed-income investments vary, though these differences are relatively straightforward. The table describes a type of security, the state and federal taxes on interest payments and the capital gains taxes you’d incur if you sell the bond before maturity.
Federal income (interest payments) | State income (interest payments) | Capital gains (sell before maturity) | |
|---|---|---|---|
Municipal bonds | Typically no | Varies by state | Yes |
Treasury securities | Yes | No | Yes |
Corporate bonds | Yes | Yes | Yes |
High-yield bonds | Yes | Yes | Yes |
How to invest in fixed-income securities
There are several ways to acquire fixed-income securities, but it's a good idea to consult with a qualified financial advisor before purchasing.
- New-issue Treasury securities. The easiest way to buy newly issued U.S. Treasury securities is through treasurydirect.gov.
- Municipal bonds. There are a few ways to buy municipal bonds, but the easiest is through a brokerage account. Most major online brokerages will have municipal bonds on offer.
- Corporate and high-yield bonds. To purchase these, you’ll need a brokerage account. Once you’ve set up your account, you can use the brokerage’s screening tools to find the bonds that best suit your situation and portfolio.
- Secondary market. You’ll need a brokerage account to buy or sell all bonds on the secondary market.
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