Fixed income broadly refers to t types of investment security that pay investors fixed interest or dividend payments until its maturity date. At maturity, investors are repaid the principal amount they had invested. Government and Corporate Bonds are the most common types of fixed-income products.
Companies and governments issue debt securities to raise money to fund day-to-day operations and finance large projects. For investors, fixed-income instruments pay a set interest rate return in exchange for investors lending their money. At the maturity date, investors are repaid the original amount they had invested—known as the principal.
For example, a company might issue a 5% bond with a ₹1,000 face value that matures in five years. The investor buys the bond for ₹1,000 and will not be paid back until the end of the five years. Over the course of the five years, the company pays interest payments—called coupon payments—based on a rate of 5% per year. As a result, the investor is paid ₹50 per year for five years. At the end of the five-years, the investor is repaid the ₹1,000 invested initially on the maturity date. Fixed-Income Investments pay coupon payments monthly, quarterly, or semiannually.
Fixed-income securities are recommended for conservative investors seeking a diversified portfolio.
Fixed-income investing is a conservative strategy where returns are generated from low-risk securities that pay predictable interest. Since the risk is lower, the interest coupon payments are also, usually, lower as well. Building a fixed-income portfolio may include investing in bonds, bond mutual funds, and certificates of deposit (CDs). One such strategy using fixed-income products is called the laddering strategy.
A laddering strategy offers steady interest income through the investment in a series of short-term bonds. As bonds mature, the portfolio manager reinvests the returned principal into new short-term bonds extending the ladder. This method allows the investor to have access to ready capital and avoid losing out on rising market interest rates.
Credit and Default Risk: When choosing a Fixed Income Instrument take care to look at the credit rating of the bond and the underlying company. Bonds with ratings below BBB are of low quality and are considered junk bonds.The credit risk linked to a Company can have varying effects on the valuations of the fixed-income instrument leading up to its maturity. If a company is struggling, the prices of its bonds on the secondary market might decline in value. If an investor tries to sell a bond of a struggling company, the bond might sell for less than the face or par value. Also, the bond may become difficult for investors to sell in the open market at a fair price or at all because there’s no demand for it.
The prices of bonds can increase and decrease over the life of the bond. If the investor holds the bond until its maturity, the price movements are immaterial since the investor will be paid the face value of the bond upon maturity. However, if the bondholder sells the bond before its maturity through a broker or financial institution, the investor will receive the current market price at the time of the sale. The selling price could result in a gain or loss on the investment depending on the underlying corporation, the coupon interest rate, and the current market interest rate.
Interest Rate Risk: Fixed-income investors might face interest rate risk. This risk happens in an environment where interest rates are rising, and the rate paid by the bond falls. In this case, the bond would lose value in the secondary bond market. Also, the investor’s capital is tied up in the investment, and they cannot put it to work earning higher income without taking an initial loss. For example, if an investor purchased a 2-year bond paying 2.5% per year and interest rates for 2-year bonds jumped to 5%, the investor is locked in at 2.5%. For better or worse, investors holding fixed-income products receive their fixed rate regardless of where interest rates move in the market.
Inflationary Risks: Inflationary risk is also a danger to fixed-income investors. The pace at which prices rise in the economy is called inflation. If prices rise or inflation increases, it eats into the gains of fixed-income securities. For example, if fixed-rate debt security pays a 2% return and inflation rises by 1.5%, the investor loses out, earning only a 0.5% return in real terms.
Pros: Steady income stream · More stable returns than stocks · Higher claim to the assets in bankruptcies · Government and FDIC backing on some
Cons: Returns are lower than other investments · Credit and default risk exposure · Susceptible to interest rate risk · Sensitive to Inflationary risk