Fixed Income Investing: Learn How to Combat Inflation Risk
“Potential principal safety, potential tax efficiency, and a dependable monthly or semi-annual income stream are the top three reasons to invest in fixed income bonds,” said Garryl Keel, LPL Financial Advisor with Central Investment Advisors.
When building a balanced portfolio, combining stocks and bonds can give you the stability you need during different market cycles. Having a well-balanced investment portfolio is important for retirees who need a steady stream of income during their retirement years, especially during an economic downturn.
How It Works
The sale of bonds through a financial institution can help a municipality or school district raise funds to upgrade or expand their facilities, it can assist corporations in bringing in capital to purchase new equipment, or provide financing when a government entity needs funding for a new bridge.
The investors in these types of bonds provide the municipality or corporation with the capital they need. In return, the investor receives a reliable amount of interest or dividends that are paid at certain intervals until the bond reaches maturity when they will also receive the original amount invested, assuming the issuer is not in default.
“These bonds, and notes vary in maturities, and can be easily staggered (or laddered) over many months and/or years to create a variety of interest income possibilities,” said Keel. “Investors can purchase U.S. Treasury bills, notes or bonds, which are backed by the full faith and credit of the federal government.”
For example, a bond investor could purchase a fixed income security valued at $5,000 with a 5% return and five years to mature. They would earn $250 per year in dividends. At the end of five years, the investor’s original $5,000 would be returned as well, assuming no default. Some bonds can also be found that pay out interest as frequently as monthly, quarterly, or twice a year.
How to Invest in Fixed Income
Investment advisors have access to fixed income vehicles and can provide a wide variety of options which fall into this category including, mutual funds, government bonds and corporate or municipal bonds, ETFs (exchange traded funds) and ETNs (Exchange Traded Notes). You can ask your investment professional for specific government, U.S. Treasury, corporate or municipal bonds.
Younger investors generally have a higher tolerance for risk and may have a smaller segment of their portfolio in fixed income investments. As investors near retirement, or the stock market becomes volatile, fixed income investing can become more of a priority.
See below for all the types of available fixed income products available.
|The Variety of Fixed Income Investments Available|
|Treasury bills (T-bills)||These bonds have some of the shortest terms of any government securities. Anywhere from a few days to 52 weeks. They are purchased at a discount to their face value and the dividend is collected at maturity when they are worth their par or face value.|
|Treasury bonds (T-bonds)||These are government bonds with the most lengthy terms, anywhere from 20-30 years. They can be purchase in increments of $100, and the pay out is twice per year.|
|Treasury notes (T-notes)||These are the middle ground of Treasury securities that mature between two and 10 years. They pay a fixed coupon rate and are issued at increments of $100. The investor will receive semiannual coupon payments during the life of the bond, and the principal at maturity.|
|Treasury Inflation-Protected Securities (TIPS)||TIPS are a US Treasury whose principal value rises and falls with the rate of inflation. As inflation moves up, the principal value is adjusted upward, as inflation falls the opposite occurs. The interest and inflation adjustments on TIPS are exempt from state and local income taxes. However, the inflation adjustment is considered taxable income by the IRS, even though investors don’t see that money until they sell the bond or it reaches maturity. A set interest rate is paid out semi-annually. At maturity, the amount returned to the investor is the larger of either the original sum invested, or the inflation adjusted amount.|
|Municipal bonds (Munis)||These are bonds issued by state or local governments or other agencies, which often offer a federal and state tax exemptions. The investor receives dividends twice per year and the principal when the bond reaches maturity.|
|Corporate bonds||Bonds are sold by corporations with the return on the investment be partially linked to the credit rating of the company issuing the bond. A corporation with a high credit rating will sell bonds at a lower percentage of interest because they are more likely to be able to return the face value (or principal) of the security.|
|High-yield bonds (junk bonds)||Somewhat opposite of a highly rated corporate bond, these fixed investments usually have a higher percentage yield because there is also a bigger risk for default.|
|A certificate of deposit (CD)||These are offered by financial institutions and reach maturity in under five years. Typically the interest rate is higher than a savings account and has Federal Deposit Insurance Corporation (FDIC) protection up to $250,000 per individual.|
Benefits and Risks of Fixed Income Investing
- Highly rated bonds provide diversity in an individual’s investment strategy when paired with stock investments because they are considered low risk with a predictable return.
- They nearly always return stable interest in the shorter term, and an almost certain return of initial capital investment if the issuer is highly rated.
- If you own bonds, you are a creditor, and if the issuer should file bankruptcy, bondholders as lenders, are paid before stockholders (owners), usually in the form of newly created equity.
- Some bonds come with guarantees such as principal guarantee or a set interest rate – ask your investment advisor for more information.
- Some government bonds, such as Munis, are exempt from federal and state income taxes.
- Returns can be lower than other investments – especially relative to the age and life stage of the investor. Bonds typically have lower returns than stock investments over a period of 10 years or more, but in the shorter term have less risk.
- Credit and default risk exposure. Companies who use the sale of bonds to raise capital, always have a risk of failing or defaulting in which case, an investor could lose all or a part of their principal.
- Interest rate risk comes into play on bond investments because when interest rates go up, bond prices fall, and vice versa. The fluctuation in prices will change the value of bonds.
- Inflation can lower the value of income earned on bonds as the prices rise on everything else.
The bottom line is, fixed-income investments can offer savers a reliable source of income over the life of the bond, while they also offer the issuer needed funds. Typically, they are a low-risk way to earn dividends and are an effective way to diversify your portfolio with a feeling similar to having a few non-perishables tucked away in your kitchen.
Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio. Diversification does not protect against risk; it is a method used to help manage portfolio volatility.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. An issuer may default on payment of the principal or interest of a bond. Bonds are also subject to other types of risks such as call, credit, liquidity, interest rate, and general market risks.
Treasuries are debt securities issued by the United States government and secured by its full faith and credit. Income from treasury securities is exempt from local and state taxes. Municipal bond offerings are subject to availability and change in price. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply. Municipal bonds may not be suitable for all investors. Please see your tax and professional prior to investing.
High yield bonds typically have lower credit ratings and carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal.