Fixed income investments, commonly known as bonds and money market securities, come in a variety of forms. They are simply loans made by an investor to a corporate or government borrower. For example, the borrower has to pay interest at a fixed rate once a year, and to repay the principal amount on maturity.
Advantages of Fixed-Income Investing
Fixed-income investments may be right for you if you want to experience these benefits as part of a diversified portfolio.
- Preserve wealth – While fixed-income prices may fluctuate, you can rely on receiving the full-face amount when your investment matures.
- Diversify your portfolio – Diversifying your investments across asset classes may result in less risk exposure for your overall portfolio.
- Generate income – Fixed-income investments may provide a steady stream of monthly or quarterly income to help supplement your income or help fund your retirement.
- Manage interest rate risk – By creating a ladder through staggered maturities, you can manage interest rate risk in both rising and falling environments and experience less exposure to interest rate volatility.
The terminology used in connection with these fixed income investments is:
- The issuer is the entity (company or government) who borrows the money by issuing the bond, and is due to pay interest and repay capital in due course.
- The principal of a bond – also known as maturity value, face value, par value – is the amount that the issuer borrows which must be repaid to the lender.
- The coupon (of a bond) is the annual interest that the issuer must pay, expressed as a percentage of the principal.
- The maturity is the end of the bond, the date that the issuer must return the principal.
- The issue is another term for the bond itself.
- The indenture, in some cases, is the contract that states all of the terms of the bond.
Fixed income derivatives include interest rate derivatives and credit derivatives are:
- Credit default swaps
- Interest rate swaps
- Inflation swaps
- Bond futures on 2/10/30-year government bonds
- Interest rate futures on 90-day interbank interest rates
- Forward rate agreements
- Investors in fixed-income securities are typically looking for a constant and secure return on their investment.
- For example, a retired person might like to receive a regular dependable payment to live on like gratuity, but not consume principal.
- This person can buy a bond with their money, and use the coupon payment (the interest) as that regular dependable payment.
- When the bond matures or is refinanced, the person will have their money returned to them.
- The major investors in fixed-income securities are institutional investors, such as pension plans, mutual funds, insurance companies and others.
Fixed income securities have risks that may include but are not limited to the following, many of which are synonymous, mutually exclusive, or related:
- Inflation risk
- Interest rate risk
- Currency risk
- Default risk
- Reinvestment risk
- Liquidity risk
- Duration risk
- Convexity risk
- Credit quality risk
- Political risk
- Tax adjustment risk
- Market risk
- Event risk
Before you invest, make sure you understand all of the risks and rewards involved.