Fixed Income Investments | Definition, Types, Examples

What is fixed income investing?

Fixed income investments are a type of investment that provides the investor with a steady stream of income on an annual or monthly basis or any other form of periodic payment. They work as follows: you lend money to the issuer - a company or the government (“lend” is the word that most easily explains the essence of fixed-income investments, because when you buy, for example, bonds, you lend your funds to a third party), and in return you receive regular interest payments. Also, at the end of the IFD term, the principal amount of the investment is returned to you.

Example:

A user buys a 10-year U.S. Treasury bond (these are government debt securities issued by the U.S. Treasury Department through its Bureau of Public Debt) for $10,000 with an annual interest rate of 4%. Consequently, he will receive $400 in interest payments each year, and after 10 years he will be repaying his $10,000.

It is worth noting that fixed income investments can be a valuable component of a diversified portfolio for a number of reasons, including a predictable and stable income stream so the user can balance out the more volatile assets in the portfolio, and risk mitigation.

What are the main types of fixed income investments?

Fixed income investments offer investors regular interest payments, making them an attractive option for those seeking a stable source of income. Government, municipal and corporate bonds, certificates of deposit, ETFs, promissory notes, mortgage-backed securities, etc. are commonly considered to be the main types of FFDs. We have described the characteristics of the main types below.

• Government bonds. These are securities that are issued by national governments to finance their expenditures. By investing in government bonds, you are investing money in the development of your own country, and the government agrees to pay you interest on the amount of the deposit. Government bonds are considered to be one of the most reliable, as they have a high probability of return on investment. Another significant advantage is a favorable tax regime

• Municipal bonds. These are bonds issued by local authorities, and the funds from their sale can be used to finance the development budget of local projects. Government bonds have higher reliability than municipal bonds. But it is believed that if local authorities cannot repay their debts to bondholders, the government will do it for them

Example of a municipal bond:

California State General Obligation Bond: Par value: $1,000, maturity: 20 years, rate: 3.5% p.a., coupon payment period 6 months. Issue date: January 1, 2023, maturity date: January 1, 2043.

The issuer (State of California) issued this bond to finance various projects such as the construction and renovation of schools, hospitals, and other public buildings. By purchasing these bonds, investors provide the State of California with the necessary capital to accomplish these projects.

Every six months, investors receive a coupon yield of 3.5% per annum on the face value of the bond. In our example, that's $17.50 every six months on each bond.

At the end of 20 years, investors will receive back the face value of the bonds - $1,000 per bond.

• Corporate bonds. This type of bond is issued by legal entities wishing to raise funds through the stock market to develop their business. Corporate bonds offer higher yields than state and municipal bonds, but also have a higher risk of default, as in this case the guarantor is the company that issued the bonds. Consequently, you are protected by virtually no external mechanisms. In addition, in most cases, to invest in corporate bonds, you need to have a significant starting amount

Example of a corporate bond:

Apple Inc. Bonds
Face value: $1,000; Maturity: 10 years; Coupon rate: 3.45% p.a.; Coupon payment frequency: Semi-annual. Issue Date: February 6, 2023; Maturity Date: February 6, 2033.

Issuer Apple Inc. issued this bond to raise capital for general corporate purposes, including refinancing existing debt, developing new products and expanding its business.

• Certificates of deposit. This is a security issued by banks. This certificate is proof that the depositor has deposited a certain amount of money in a bank account and has the right to get it back together with interest after a set period of time. They often have low yields but are insured by the government up to a certain amount

• Bond exchange-traded funds (ETFs). Investment funds that buy a basket of different bonds. They allow to diversify investments and reduce risks. Profitability directly depends on the composition of the fund

• Bills of exchange. This type of security is similar to a promissory note, according to which the promissor (the one who issued the promissory note) undertakes to pay the creditor (the one who purchased the promissory note) a certain amount in a certain period of time. As with a receipt, the promissory note holder may undertake to repay the money with or without interest. The amount of interest is determined by the promissor, and the creditor, in turn, already decides whether to agree to the established conditions or not. The main risk - not returning the money paid for the bill of exchange - may arise in several cases: the bill of exchange was issued by fraudsters or it was incorrectly executed

What are the main pros and cons of fixed income investing?

To make it clear to you whether you should opt for fixed income investments, we have compiled the main pros and cons of this type of investment.

How to start fixed income investing?

If you plan to invest in fixed income instruments, consider key factors such as credit rating, interest rate and inflation risks, yield, liquidity and diversification.

• Credit quality and risk assessment. This is one of the most important aspects of selecting investment instruments. Credit quality assesses the ability of a borrower (company, government, etc.) to repay its debt. Consequently, the higher the credit rating, the lower the probability of default. Usually, government bonds lead the way in terms of reliability, as the national government acts as a guarantor of repayment, while corporate bonds issued by companies have a higher level of risk

• Interest rate risk. The risk that average market rates on similar bonds will become higher and the investor will be a loser. Suppose an investor purchased a three-year bond with a fixed interest rate of 10% per annum. One year later, the average market yield on similar bonds has risen from 10% to 12%. This automatically makes bonds with an interest rate of 10% less attractive; as a consequence, the investor will earn less than those investors who bought the bonds under the new terms. And if the investor wants to sell his bonds early, he will have to reduce the price below par. This is interest rate risk - the potential loss of value of the bond due to changes in interest rates on the market

• Yield. Different instruments have different yields. For example, short-term bonds usually have lower yields than long-term bonds, but they are less susceptible to changes in interest rates. Therefore, in this case, investors should decide in advance on their investment goals (saving for retirement, receiving regular income, creating a reserve fund, etc.) and time horizons (whether they need the money in the near future or have the opportunity to invest in the long term)

• Liquidity. It is also important to consider the liquidity of the instrument, i.e. how easily it can be sold without significantly affecting its price

• Inflation risks. There is a possibility that inflation may overtake bond yields, so that you will not only fail to increase your real capital, but also lose part of it. Investors should consider the potential impact of inflation on their portfolio and look for instruments that can protect it from this risk

• Diversification. Don't invest all of your funds in one instrument. Spread them across different types of IFDs to balance risk and return

Best fixed income investments

For beginning investors, the easiest way to access diversified fixed-income investments is bond mutual funds and ETFs (exchange-traded funds). Why? There are several good arguments: risk diversification, minimal investment (you'll typically need less money than buying individual bonds), and high liquidity.

Below we have ranked some of the most profitable options and described their main characteristics.

Important note:

Bond yields are constantly changing, so this ranking cannot be considered a financial recommendation. Do your own research before investing.