Fixed Income Investing: A Stable Source of Income

Lower Volatility, Stable Return

Fixed income investments refer to any investment that has a fixed and stable return.  This contrasts with equity investments which float in value with the vagaries of the markets and do not have a stable, fixed return.  Examples of fixed income investments are government bonds (including T-bills and Muni’s), Certificates of Deposit (CDs), and Corporate Bonds.  Fixed income investments offer a stable and less volatile, fixed payout and are considered conservative investments for investors looking for stable investment income.

How They Work

Let us assume that an investor buys a $1000 bond from Company A at 10% for 2 years.

• This means that the investor loans Company A $1000 today in return for $100 (10% of $1000) at the end of this year and the following year (2 years) plus the original $1000 principal at the end of the 2 year period.

Company A will be able to use the $1000 today to invest in its business and the investor will have stable and predictable annual income of $100 for 2 years.

Terms to Know

There are several terms that an investor must know in order to understand fixed income investments. 

• In the above example, the issuer is the entity – in this case Company A – that borrows the money from the investor. 
• The principal is the amount that the issuer borrows – in this case, $1000. 
• The coupon is the interest that the issuer must pay – in this case, $100.
• The maturity period is the payback period after which the issuer must pay the principal back to the investor – in this case, 2 years.

Benefits and Drawbacks

Although fixed income investments offer stable income, there are some main risks that must be understood by the investor:

• Default Risk – Different issuers offer bonds with different coupon rates based on the perceived ability of the issuer to pay the investor back.  The larger the risk that a company will default on its payments, the larger the coupon rate that the investor receives to compensate for that risk. 

• Rating agencies such as Moody’s and Standard and Poor’s rate the issuer’s default risk and assign bond ratings which help guide investors.  Ratings range from AAA (the highest investment grade) to CCC or below (distressed debt).

• Inflation Risk – Because fixed income investments pay specific and stable amount they are subject to the risk that the rate of inflation will be higher than the coupon rate, thereby eroding the value of the investment.

• Liquidity Risk – Equity investments and regular bank accounts are liquid, meaning that an investor has the ability to convert the investment into accessible cash at any time.  This contrasts with a fixed income investment which is tied up for a specific period of time. 

• Tax Issues –      The fixed income that the investor receives is considered taxable income, and this can have certain tax consequences for the investor

• Some forms of fixed income investment, such as local government Municipal Bonds, are tax free.

Getting Financial Help

As always, it is integral that an investor contacts a qualified professional with any questions that he may have.  Fixed income investments, though stable, do have subtle risks that need to be understood.  A professional, for example, can help the investor understand personal tax issues that may arise from a fixed income investment.  A qualified professional should be contacted whenever an investor needs financial help.