What is fixed income
Fixed income refers to investments that pay a set stream of cash flows. Most often that cash flow is interest. The most common fixed income asset is a bond. But fixed income also includes notes, bills, certificates of deposit, and some loans.
The key idea is predictability. You know the payment schedule or you can estimate it. That makes fixed income useful for steady income, safety, and balance in a portfolio.
Main types of fixed income
- Government bonds: Issued by national governments. Examples: U.S. Treasury bills, notes, and bonds.
- Municipal bonds: Issued by cities or states. Often tax-exempt at the federal level.
- Corporate bonds: Issued by companies. Risk and yield depend on company health.
- Certificates of deposit (CDs): Bank products with fixed interest and set terms.
- Mortgage-backed securities: Bundles of home loans converted into tradable bonds.
- Asset-backed securities: Backed by other loans, like auto loans or credit card debt.
- Preferred stock: Sometimes treated as fixed income because it pays fixed dividends.
Key terms
- Par value: The face amount of a bond. Usually $1,000 per bond.
- Coupon: The annual interest paid on the bond, usually a percentage of par. Example: A $1,000 bond with a 5% coupon pays $50 a year.
- Current yield: Annual coupon divided by the bond price.
- Yield to maturity (YTM): The total return if you hold the bond to maturity and reinvest payments at the same rate. It includes price changes and interest.
- Maturity: When the bond returns the par value and stops making payments.
- Credit rating: A score given by agencies like S&P and Moody's that measures default risk.
How price and interest rates interact
Bond prices and interest rates move in opposite directions. If new bonds offer higher interest, existing bonds with lower coupons become less valuable. If rates fall, older bonds with higher coupons become more valuable.
Simple example:
- You own a $1,000 bond with a 5% coupon. It pays $50 a year.
- New bonds now offer 6% on $1,000. Investors want the higher yield.
- To sell your bond, you must lower the price so the $50 payment equals a 6% return. That means your bond price drops to about $833.
This inverse relationship is why interest rate changes matter to bond investors.
Duration and interest rate sensitivity
Duration measures how sensitive a bond is to interest rate changes. Longer duration means bigger price swings when rates change. Duration depends on:
- Time to maturity
- Coupon size
- Yield
Short-term bonds and high coupon bonds have lower duration. Lower duration means less price risk.
Risks in fixed income
- Interest rate risk: Price loss when rates rise.
- Credit risk: The issuer may default and miss payments.
- Inflation risk: Inflation can erode the buying power of fixed payments.
- Reinvestment risk: Coupons or principal may be reinvested at lower rates.
- Liquidity risk: Some bonds are hard to sell quickly without a big price change.
- Call risk: Some bonds can be repaid early by the issuer, often when rates drop.
Why investors use fixed income
- Income: Regular interest payments provide predictable cash flow.
- Capital preservation: Many bonds return principal at maturity.
- Diversification: Bonds often move differently from stocks, lowering overall portfolio risk.
- Tax benefits: Municipal bonds can be tax-exempt for local investors.
Fixed income is not always safe. Government bonds are safer than subprime corporate bonds. You must match the choice of bond to your goals and risk tolerance.
How to choose fixed income investments
- Define your goal: income, safety, or total return.
- Pick a time horizon: short, medium, or long term.
- Check credit ratings: higher rating means lower default risk.
- Compare yields: higher yield often means higher risk.
- Consider taxes: look at municipal bonds for tax-free income.
- Think about liquidity: do you need to sell easily?
How fixed income fits into a portfolio
A common rule is to hold more bonds as you get closer to needing the money. Bonds can lower overall portfolio volatility. They also provide cash flow while stocks grow.
Example mix by age:
- Young investor: 20% bonds, 80% stocks
- Mid-career: 40% bonds, 60% stocks
- Near retirement: 60% bonds, 40% stocks
Adjust these numbers for your personal goals and risk tolerance.
Simple example of yield to maturity idea
Imagine a 2-year $1,000 bond with a $50 yearly coupon. You buy it for $950. You will get $50 this year, $50 next year, and $1,000 back at the end. The yield to maturity is the interest rate that makes these cash flows equal to $950. The math uses a formula, but the idea is total return if you hold to maturity.
Final points
Fixed income means reliable payments, not risk free payments. Know what kinds of risk you face and match investments to your goals. Use credit ratings, compare yields, and mind maturity and duration. For steady income and lower volatility, fixed income is a key building block in investing.
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