Fixed-income investments, like government and corporate bonds, are an essential component of a well-balanced investment portfolio. They offer a reliable source of income with comparatively lower risk when contrasted with other investment options.
What is Fixed-Income Investing?
Fixed-income investments, unlike many other types of assets, don’t require selling to generate profits. To elucidate this concept, let’s focus on one of the most common forms of fixed-income investments: bonds.
Bonds essentially represent a loan from you to a corporation or government entity, and they offer interest payments over a specific duration, along with the return of the principal amount at the end of the predetermined term. For instance, if you purchase a 10-year bond with a face value of $5,000 that yields a 3% interest rate, you will receive $150 annually for ten years. These interest payments can be distributed at different intervals, such as monthly, quarterly, or semi-annually. After a decade, you’ll have earned $1,500 in interest, and the issuer (be it a government or corporation) will return your principal amount of $5,000.
The periodic interest payments from fixed-income investments are at your disposal for any use. However, it’s important to note that these payments are subject to taxation, although there are nuances to consider, as detailed below.
A Deeper Look at Bonds
It’s worth mentioning that bonds, much like stocks, can be bought and sold in the secondary market, often facilitated through online brokerage platforms. This market trading provides an option for potentially selling fixed-income investments for a profit, although most investors primarily seek regular income rather than capital gains.
Fixed-income investments extend beyond bonds and encompass various instruments, including preferred stocks and bank certificates of deposit. Nevertheless, for many investors, bonds constitute the bulk of their fixed-income holdings.
The Significance of Fixed-Income Investments in Your Portfolio
Fixed-income investments offer several advantages, making them a vital component of any investment portfolio.
Diversification is one of the primary reasons for including fixed-income investments. Diversifying your portfolio aims to reduce volatility by spreading risk. While diversification can be achieved through stocks alone, investing in various companies across different sectors, fixed-income investments provide an added layer of stability. This is because bond values often move in opposition to stock values.
Bonds tend to rise when stocks fall, as they are perceived as a safer haven during volatile market periods. In practical terms, if the stock segment of your portfolio experiences a 10% decline but the bond segment gains 4%, your overall loss is only 6%.
Brett Koeppel, a certified financial planner, describes fixed-income investments as “shock absorbers” against market downturns. He recommends diversifying across different asset classes to ensure your investments align with your financial goals.
When determining the right allocation between stocks and bonds, consider your overall financial situation and when you intend to utilize your investments. Advisors typically recommend shifting toward fixed-income investments as retirement approaches. Doing so minimizes the risk of market turmoil adversely affecting your portfolio just when you need your investments the most.
While bonds are generally less risky than stocks, they do come with certain risks.
- Default: When investing in bonds, it’s essential to assess the creditworthiness of the issuer. This evaluates the likelihood of the government or company repaying its debt to you. If the issuer declares bankruptcy, interest payments cease, and you might not recover your full principal. Credit quality ratings, available through firms like Moody’s Analytics and Standard & Poor’s, can help gauge an issuer’s creditworthiness. Investment-grade bonds are considered the least likely to default and typically have ratings of BBB or above (Standard and Poor’s) or Baa and above (Moody’s). Bonds below this threshold are often referred to as high-yield or junk bonds.
- Interest Rates: A significant portion of a bond’s value comes from its fixed interest payments. If overall interest rates rise, newly issued bonds with higher interest rates become more appealing, reducing the market value of older bonds with lower interest rates. Conversely, when interest rates decline, older bonds with higher interest payments become more attractive than newer bonds with lower interest rates.
- Low Returns: While bonds offer lower risk, they often yield lower returns compared to stocks. Investors typically allocate more of their portfolio to stocks in their early years, gradually transitioning to bonds as retirement approaches. This strategy balances long-term growth with reduced risk as retirement nears. An all-bond portfolio, even with diligent saving, may not provide sufficient growth for retirement.
Types of Fixed-Income Investments
A variety of fixed-income investments are available, but the most common categories include:
Treasurys, issued and backed by the U.S. government, represent the safest form of fixed-income investment. They are available in three formats: bills (up to one year), notes (2, 3, 5, 7, or 10 years), and bonds (20 or 30 years). The likelihood of the U.S. government defaulting on these bonds is virtually nonexistent, making them a secure long-term investment with consistent returns.
Municipal bonds, akin to Treasury bonds, are issued by state and local governments. They function similarly but often provide an additional benefit: federal tax exemption. Interest generated by municipal bonds is usually exempt from both federal and state taxes, making them an attractive option for investors in high tax brackets.
Corporate bonds are slightly riskier than municipal and Treasury bonds but offer higher returns. These bonds involve lending money to corporations, and the safety of your investment depends on the issuer’s creditworthiness. Well-established companies with high credit ratings are less likely to default, making their bonds a reliable choice for fixed-income investors.
High-yield bonds, often referred to as junk bonds, offer higher interest payments in exchange for increased risk. While they fall below the investment-grade threshold, they make up a portion of the fixed-income market and can be an option for investors seeking greater returns.
All the fixed-income investments mentioned can be accessed through mutual funds and ETFs, providing diversification through a single investment.
Taxes on fixed-income investments differ based on the type of security, state, federal taxes on interest payments, and capital gains taxes for selling the bond before maturity. Here’s a breakdown:
- Federal Income (Interest Payments):
- Municipal Bonds: Typically, no.
- Treasury Securities: Yes.
- Corporate Bonds: Yes.
- High-Yield Bonds: Yes.
- State Income (Interest Payments): Varies by state for municipal bonds.
- Capital Gains (Sell Before Maturity): Yes for all types of bonds.
Investing in Fixed-Income Securities
Ready to start generating fixed income? Here’s how:
- New-Issue Treasury Securities: You can conveniently purchase newly issued U.S. Treasury securities through treasurydirect.gov.
- Municipal Bonds: The easiest way to acquire municipal bonds is through a brokerage account, available at most major online brokerages.
- Corporate and High-Yield Bonds: To purchase these bonds, you’ll need a brokerage account. Once your account is set up, use the brokerage’s screening tools to find bonds that align with your financial situation and portfolio.
- Secondary Market: If you wish to buy or sell bonds in the secondary market, you’ll also need a brokerage account.
Incorporating fixed-income investments into your portfolio can provide stability, diversification, and a consistent income stream, making them a valuable asset for investors looking to maximize returns while managing risk.