Investing Unit 5: Fixed-Income Investing

Personal Finance November 17, 2015 Print Friendly and PDF

 


 

In Unit 4, you explored characteristics of equity investments such as real estate and stock. This unit will discuss general characteristics of fixed-income securities and describe 15 specific types of these investments. There are two general categories of investments: ownership and loanership. With "ownership" assets, investors own all or part of an asset (e.g., real estate, corporation). They buy shares of company stock or growth mutual funds or, perhaps, a rental property. In other words, as an owner, they have an equity or ownership interest in a company or property, and their principal and investment earnings fluctuate with market conditions and other factors (e.g., company earnings) that affect an asset’s selling price.

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Fixed-income investments, on the other hand, are "loanership" assets; investors loan their money to a government entity (e.g., state), corporation, or financial institution (e.g., bank, credit union) and receive interest on a regular basis (e.g., monthly, semi-annually). The rate of interest paid can either be fixed for the life of an investment (e.g., Treasury securities) or can fluctuate with the general movement of interest rates (e.g., Series EE savings bonds). The principal (amount of original investment) is returned at maturity (the date on which principal must be repaid), although its value can fluctuate (if sold beforehand) according to changes in interest rates. For many fixed-income securities (e.g., bonds), as interest rates rise, asset prices decline and, as interest rates decline, asset prices rise. This inverse relationship of interest rates and asset value, called interest rate risk, affects the value of fixed-income securities if you have to sell them prior to maturity. In other words, you could lose principal if interest rates rise and you have to sell early.

Why Buy Fixed-Income Investments?

There are many reasons to consider fixed-income investments. One is that they add diversification to an investor’s portfolio. Research by several Nobel prize-winning economists found that, for every level of investment risk, there is a "best combination" of assets that produces the highest rate of return. Investing in just one asset class (e.g., stock, bonds, or cash), however, is less desirable than selecting a combination of assets because doing so increases investment risk. It’s like the old saying "don’t put all of your eggs in one basket." By combining investments that are affected differently by economic events, investment risk is reduced. While both stocks and bonds often are similarly affected by interest rates in the short run today, over the long term they have had a relatively low relationship to each other. The technical word for this is correlation, which is a statistical term that indicates the degree to which the movement of one variable (in this case, an asset class price) is related to another.

Besides diversification, there are several other reasons to consider fixed-income securities. First, they are a good option for conservative investors who are fearful of ownership assets. If the price fluctuations of the stock market are likely to cause sleepless nights, fixed-income investments like bonds are less risky because investors are less likely to lose principal. Most fixed-income securities also provide a predictable stream of income. This can be an advantage for current or near retirees who seek regular income to supplement a pension and/or Social Security.

Predictability of investment return is a third feature of fixed-income securities. The rate of return is fixed for the life of most investments and a certain amount of income can be counted upon (e.g., a 6% interest rate on a $1,000 corporate bond will pay $30 semi-annually). Some fixed-income investments also provide tax advantages. Fixed annuities, for example, are tax-deferred and municipal bond interest is federally tax-exempt. Some investments (e.g., bond funds) also allow investors to reinvest earnings, plus most fixed-income securities typically earn a higher return than bank accounts. This is especially true for substandard grade bonds rated less than Baa by Moody's or BBB by Standard & Poor's. Investment yields generally increase as the credit quality of a bond issuer drops. Thus, investors can increase their income by purchasing lower-rated bonds. Further information about bond ratings is available in many public libraries. Fixed-income securities with longer maturities (e.g., 30-year bonds) typically pay a higher interest rate than shorter-term investments (e.g., 10-year bonds) to compensate investors for having their money "tied up" for additional years and for increased exposure to price fluctuations caused by interest rate risk.

Some fixed-income securities also have capital gain (or loss) potential. Capital gains can accrue if investments are sold in secondary markets at a premium (more than their face value) prior to maturity. Gains occur when interest rates decrease and bond prices rise. A final feature of fixed-income investments is affordability. Most investment products in this category require a minimum purchase of $1,000 or less. Even among municipal bonds, which generally require $5,000, some issuers offer smaller denomination "minibonds" that provide tax-exempt income to small investors. Ginnie Maes, which require $25,000 to purchase directly, can be bought in $1,000 units through unit investment trusts (UITs). Series EE bonds can be purchased for as little as $25 and I bonds for $50.

Next, we will briefly examine 15 fixed-income investments and five general tips for fixed-income investing. The list begins with securities sold at banks, followed by various types of bonds and other fixed-income investments that are generally sold by brokers.