What is Fixed Income?

Investing in fixed-income securities is like investing with a timer...

Every time the timer goes off, you receive periodic interest payments. But not even the lowest-risk fixed income securities are risk-free. There is a chance the timer goes off, and you don’t receive the payment. You could also lose some or all of the principal you invested. Conservative investors prefer fixed-income securities, but no investor is immune from risk.

We’ve provided a general definition, but let’s delve deeper into fixed income securities to get a comprehensive picture.

Companies and governments need to raise cash for a variety of purposes— from running operations to starting and building new projects. Instead of borrowing from financial institutions, they can issue fixed income debt securities that provide investors who purchase them a return in the form of fixed interest rates paid periodically. There’s also the promise of an eventual return of the principal (or initial) amount of investment when the security matures.

Much of the time, you buy a bond for 100% of its face value, and when it matures, you redeem it for 100% of its face value. But that doesn’t guarantee you will receive all of your money back. Some companies may default on their bonds, causing them to go down in value. When companies enter bankruptcy, bond investors generally have a better chance of recovering their investment than stockholders. In other words, bondholders generally have priority over stockholders. But in most situations, bondholders have to settle for a percentage of the original principal amount.

Fixed income securities can be categorized into two buckets: short-term and long-term securities. Short-term fixed income securities have a short term to maturity. Long-term fixed income securities mature several years, and up to 30 years, after they are issued.

Here is a brief overview of short-term and long-term fixed-income securities

Short-term fixed income securities:

• Treasury bills are short-term fixed income securities issued by the federal government. They mature within a year and do not make regular interest payments. Typically, investors buy Treasury bills at a price less than its face value(‘discount’) and make a profit when the bill matures.
• An example of a short- to medium-term fixed income security is a Treasury note. A Treasury note, or T-note, matures between two and ten years. Investors receive coupon, or interest payments semi-annually as well as the principal amount of investment at maturity.
• A Certificate of deposit (CD) is a fixed income security issued by financial institutions. CDs mature in less than five years and generally pay a higher rate of interest than a standard savings account.

Medium-term and Long-term fixed income securities:

• Treasury bonds are also fixed income securities issued by the federal government and withy maturities up to 30 years.
• Investors worried about inflation can choose the Treasury Inflation-Protected Securities (TIPS). TIPs are long-term fixed income securities where the principal adjusts with inflation and deflation.
• Municipal bonds are debt securities issued by states and local jurisdictions. Interest on municipal bonds is generally exempt from U.S. federal taxation. If the investor resides in the state that issues the bond, he or she is typically exempt from state income taxes on the interest as well.
• Corporate bonds are issued by public and private companies. They are typically riskier than government-issued debt securities Because as issuers of these securities, governments have relatively higher levels of creditworthiness than individual companies. A corporate bond’s issuance price and coupon are tied to its credit rating.
• Corporate bonds with lower credit ratings are called junk bonds. Companies pay a higher coupon than typical corporate bonds due to the increased risk of not being able to pay the investors the principal or all of the interest. These are typically issued by companies to fund acquisitions, special projects, as well as on-going operations of the firm.
• A fixed-income mutual fund invests its assets into a portfolio of bonds and debt instruments. A professional management company will do this on behalf of the fund’s investors. The investor is charged a management fee for these services.
• Fixed-income ETFs also work like mutual funds. A professional management team handles these and charge the investor a management fee for targeting certain credit ratings and durations investments. While ETFs can be easily traded, they can also be held as long-term investments.

Investors tend to like fixed income securities because they can provide a consistent income. They’re especially popular among retirees who are looking for steady income on investments to finance their living expenses. Issuers of fixed income securities utilize them because it offers them access to much-needed capital for operations or large projects.

They also add to the diversification of investment portfolios by providing alternatives to stocks. When stocks fluctuate in value, losses can be offset with interest payments received from fixed income securities. Simply put, fixed income investments offer a certain degree of security. Securities such as Treasury bonds have the backing of the U.S. government that makes them even more reliable as fixed income investments. Similarly, CDs come with the protection of up to $250,000 per individual from the Federal Deposit Insurance Corporation.

One of the significant risks that investors take with fixed income securities is inflationary risk. When inflation occurs, prices for goods and services overall go up. This means your money is worth less than it was previously. In order to protect the purchasing power of your money, you need returns that exceed the rate of inflation.

Let’s say you invest $10,000 into a bond that pays 3% interest. After a year, you have earned $300 on your investment. However, inflation for the year is 3%. That means $10,300 today buys you the equivalent of $10,000 worth of goods this year. While your investments have kept up with inflation, in effect you have made no money for the year.

Returns on fixed income securities are generally lower than other investments. The lower the risk on an investment, the lower the return, While they may be less risky, fixed income securities aren’t entirely risk-free. The issuer of a fixed income security may default on the interest payments, as well as repayment of the principal amount upon maturity.

Some investors use derivatives to manage risk. Derivatives are a bet on the direction of a certain security. The holder of a derivative does not own the underlying asset. Please note that the following approaches are very risky and not recommended for the average investor. They are also very complex so require extensive education before investing.

Options, futures, and forwards are examples of derivatives. They allow investors to take positions without having to put the full amount of money upfront. Institutional investors typically use these hedging strategies. A minority of small investors may use them as well. Retail investors may use options to speculate on the future prices of stocks. They may also use them to help reduce downside risk in their portfolio.

Here are some of the different types of fixed income derivatives.

• Options give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) a specific security at a certain price on a future date.
• Futures contracts bind the buyer and seller of the contract to execute the trade at the contract’s maturity date. Forward contracts are traded over-the-counter (decentralized market), unlike listed options that are traded on an exchange. They are like futures contracts but customized to the needs of the parties involved. The buyer and a seller set a price for a future point in time for the sale to occur.

Here are two examples of fixed income derivatives

• Interest rate swaps enable bondholders to swap their future interest rate payments. Similar to futures contracts, it is a contract between the holder of a fixed-interest bond and a flexible-interest bond. This trade happens over-the-counter. For example, investor A makes payments to Investor B on a fixed-interest rate. Investor B makes payments to Investor A, based on a floating interest rate, which is tied to a reference rate (an interest rate that determines another interest rate).
• The value of mortgage-backed securities is derived from bundles of home loans. This investment offers a rate of return based on the assessed risk of the underlying mortgage portfolio. The bank becomes the middleman between a homebuyer and the investment industry. With a mortgage-backed security, when the investor buys it, he or she lends money to the homebuyer. The bank grants mortgages to its clients and sells it at a discount for inclusion in a mortgage-backed security.

The most common fixed income investment is a bond. We’ve established that bonds function as an IOU (binding legal document detailing a specific debt obligation) with an investor (aka lender) lending his or her money to an issuer (aka borrower) for a predetermined period in return for interest payments over the term of the investment and the principal at maturity. What are the factors to consider when investing in bonds?

An investor has to decide whether to invest in individual bonds or bond funds. Individual bonds allow the investor to control cash flow by matching the maturity date of a bond to the investor’s specific income needs. But it may be hard for small investors to diversify by buying individual bonds. Transaction costs can eat up a large share of returns. It is also tough to diversify a small portfolio since most corporate bonds are sold in denominations of $1000.

This is why bond funds can be cost-effective and convenient. Institutional buyers can buy at rates unavailable to retail investors. They offer diversification, with reduced transaction costs. However, bond funds do come with annual management fees.

There are many ways to invest in fixed income securities. Investors can buy exchange-traded funds (ETFs) and mutual funds that invest in government and corporate bonds. Investors can also choose from fixed income products such as certificates of deposit (CDs) and municipal bonds. Variable-income securities differ from fixed-income security due to changes in payment based on underlying measures like short-term interest rates. With fixed-income securities, investors know the payments in advance. Investors should know that bonds trade over-the-counter (OTC) on the bond market. OTC is the process of trading securities that are not listed on a formal exchange such as the New York Stock Exchange - It’s done via a broker-dealer network. The OTC market is less liquid than formal exchanges, making it harder for small investors to enter and exit positions.

• Bond index funds are low cost (management fees are lower than that of actively managed bond funds) and are intended to mirror the performance of a specific index or a market benchmark.
• Bond ETFs are a more liquid way to invest in bond indices. A Bond ETF is an exchange-traded fund that invests in bonds.
• Another option is investing in actively managed bond funds where an investment manager picks bonds that he or she believes will outperform a fund’s benchmark. This option offers investors potentially higher returns than bond index funds but at higher fees.

Given that a fund can sell bonds before they reach maturity to maintain portfolio allocation (keeping the fund’s diversification within set parameters) or fund redemptions, an investor may not get the exact return for the underlying bond holdings. However, yields to maturity provide a good guide for an investor. Another factor that investors must consider before buying bonds is effective duration. It serves as a measure to forecast increase or decrease in the value of a bond fund when interest rates change. It helps to determine the response of the bond fund, giving investors a clearer picture of whether a particular fund is within their investment risk tolerance.

Disclosures: Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors.

Keep in mind, options trading has significant risk and isn’t appropriate for all investors — and certain complex options strategies carry even additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. Investors should absolutely consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.