A Complete Guide to Fixed Income: Types and How to Invest in Fixed Income

Thanks to the global economic slowdown and geopolitical conflicts, investors are looking for low-risk investment options. The equity market is becoming volatile day by day. In that case, fixed income investments are here dressed as rescuers. Fixed-income securities hold a special place in the heart of investment individuals seeking secure and predictable returns. 

For a balanced portfolio, having a fixed-income investment is critical whether you are just starting or you are an experienced investor. A low-risk asset in your portfolio will help you in tough times, just like an elder brother. 

In this article, we are going to look at how fixed-income securities work, and how you can handle the complexities of investing in fixed income such as government bonds, corporate bonds, and exchange-traded funds (ETFs). 

What is fixed income?

As the name suggests, Fixed-income investments offer a consistent stream of fixed-income or dividend payments until they mature. Some of the most famous bonds like government bonds or corporate bonds are a type of fixed-income security. These fixed income investments primarily include treasury bills, government bonds, certificates of deposits, and other debt instruments. 

Although stocks always found their place in the news, fixed income investing stays at the back door, always ready to help. Therefore, fixed-income funds gain when stocks fall. These are also called heaven for companies that do not issue equity. Fixed-income securities are also used as retirement income, investors invest in bonds and forget about them until their maturity date. 

How Fixed Income Securities Work?

Whenever a corporate house or federal government requires capital to fund its initiatives, it issues fixed-income securities, mainly bonds. These securities are issued to the public in return for money. A bond, which is a synonym word for fixed income, is a contract or IOU agreement. Here an agreement means a loan issued by the company and purchased by an investor. In return for that favor, the company or government promises two things:

1. To reward interest payments regularly until the bond matures.
2. To pay back the principal amount on a fixed date, also called at maturity date. 

The company that issues bonds or debentures is in due diligence to pay the interest and principal in priority before the shareholder's payment. Bonds can be purchased directly from the company or they also trade in the secondary market. However, if an investor purchases a bond directly from the organization, he pays the face value, the same is not the case with the secondary market. Bonds in the secondary market may trade at a discount or at a premium. Please note that, while it is difficult to get bonds allotted directly from the company, there is a liquidity issue in the secondary market. You may not find a seller for your bonds. 

Let’s take an example to understand the concept of fixed-income securities:

Assume Intero Digital, a digital marketing company in the USA needs capital for expansion. The company holds a good bond rating and is looking for $1 million. Intero Digital issues bonds with a par value of $100. 

Suppose, an investor purchased directly from the company. According to the terms, the bond will pay, let's say, 10% annually on the par value of $100 and comes with a maturity of 5 years.

Therefore, in the above example, Intero Digital will pay 10 dollars per year for up to 5 years. At the time of maturity, the bondholder will receive a payment of $100 and will have earned $50 already.

Read Also:- Stocks Vs Bonds: A Roadmap To Grow Your Wealth Effectively

What is the credit rating of fixed-income securities?

Credit rating is the opinion of the rating agency on the relative ability of the issuer of debt instruments (Bonds) to meet the debt service obligation. In simple words, rating agencies take into account various factors to determine whether a company issuing a bond can pay the interest and principal amount on maturity. Rating is usually expressed in alphabetic or alphanumeric symbols such as AAA, A, or BB. These ratings help investors differentiate between bonds based on their underlying credit ability. In short, credit ratings establish a link between risk and return. It is always advised that an investor should check credit rating before investing in any fixed-income security. Every individual bond holds a separate credit rating. 

The first mercantile credit agency was set up in New York in 1841 to rate the ability of merchants to pay their financial obligations. 

Types of Fixed Income Securities

Treasury Investments	Bonds Investments
Treasury bonds, Treasury billsTreasury notes, Treasury Inflation-Protected Securities (TIPS)	Corporate bonds, Municipal bonds, High-yield bonds

Treasury Investments

Treasury investments can also be called investor’s favorite fixed income investments. These are issued by the government of the USA, and because of that, There is almost zero risk of losing money irrespective of the term of investment. 

1. Treasury bonds

Generally referred to as T-bonds, these are some of the longest-serving bonds. They are issued in multiples of $100 and come with a maturity of 20 or 30 years. Interest on these treasury bonds is mostly paid semiannually. They are by far the best fixed-income security for investors looking for regular interest payouts. What’s more, they are called retirement-friendly investment options. Recently the US government sold 30-year and 20-year treasury bonds in November 2023 with a total value of $26 billion and $16 billion respectively.

2. Treasury bills

Unlike treasury bonds, treasury bills are short-term fixed-income securities. Treasury bills or T-bills mature in between a few days to 52 weeks. In simpler terms, T-bills are short-term securities that mature within one year. Treasury bills don’t pay any interest, therefore, they are issued at a discount and mature at face value. The difference is the earnings of investors.

For example, an investor purchased a T-bill at a $950 discounted price with a face value of $1000. At the time of maturity (Within one year) the investor will receive the total amount based on face value i.e. $1000. Thus, a gain of 50 dollars.

3. Treasury notes

We have talked about long-term securities and short-term securities. It's high time we focus on mid-term security. Treasury notes or T-notes are mid-term securities that expire between two years to ten years. Most T-notes carry a maturity of two, three, five, seven, and ten years. Like treasury bonds, T-notes are also offered in multiples of $100 and interest is paid semiannually.

4. Treasury Inflation Protected Securities (TIPS)

As the name suggests, Treasury inflation-protected securities (TIPS) are part of a fixed income portfolio that protects investors from inflation. The concept of TIPS is very simple to understand. In the case of inflation, the principal amount increases. And, in Deflation, the principal amount decreases. To keep transparency, it is measured by the consumer price index (CPI).

There is another benefit of investing in Treasury inflation protected securities (TIPS), interest rates are tied to the principal amount, so, along with principal, interest also increases in inflation and decreases with deflation.

Bond Investments

A bond is essentially a loan that is turned into a security. It is an IOU (I owe you) agreement between the issuer and the investor. The bond market is the world's largest asset class after only real estate. It is approximately three times bigger than the equity market.

1. Corporate Bond

Whenever a corporate organization plans to raise funds, it offers bonds. These bonds are called Corporate bonds. These bonds could be short-term or long-term in nature. However, here credit rating plays a major role. The interest payout is decided considering the credit rating of the corporation. The higher the credit rating, the lower the yield, and the lower the credit rating, the higher the interest. 

For example, if a company holds a high credit rating such as AAA or AA, the coupon rate would be the lowest. Similarly, when a company holds a weak credit rating, the coupon rate would be the highest.

2. Municipal bonds

Municipal corporations have limited borrowing options, and bonds are the most popular option among them. Municipal bonds are the same as corporate bonds but with better security and benefits. These are issued by state governments, municipalities, or other state agencies. Because they are offered by government institutions, they come with certain benefits such as tax exemption from federal income tax. They pay interest semiannually just like other fixed-income securities.

3. High-yield bonds

As the name indicates, High-yield bonds offer high coupon payout. Also known as junk bonds, these bonds may offer high yields but also bring risks attached to them. The reason such bonds can offer sky-high yields is low credit ratings and greater risk of default. Such bonds are offered by small or mid-size corporations to scale businesses.

Advantages of Fixed Income Securities

1. Orderly income

Regular income is the best source of income, isn’t it? Thanks to fixed interest payments, Investors generate a regular flow of income. These fixed-income securities are great for people looking for predictable income. Securities such as treasury and bonds offer more certainty than other investments.

2. Low-risk assets

Due to geopolitical conflicts and recessionary waves, the equity market and other forms of investment have become volatile. Therefore, in that case, fixed income is the best possible option to avoid uncertain risk. Although bonds are not 100% safe, there are risks such as credit or default, the security they offer is way better than other investment options. 

3. Diversification

Investing in fixed income is a considerable option for diversification. By virtue of their nature, the Fixed-income source tends not to move in the direction of the equity market. Hence they are called safe-haven investments. For instance, in 2008, due to the great recession, the equity market crashed by 37%, but treasury bonds climbed almost 20%. The ability of bonds to move in the opposite direction of equities makes it one of the best investments for a diversified portfolio.

Drawbacks of Fixed-income securities

1. Interest rate risk

Even though the fixed income portfolio is considerably safe and secure, Federal Reserve’s Interest rates negatively impact the price of bonds and treasuries. Bond prices fall when interest rates rise and vice versa. Whenever the Federal Reserve tries to control inflation, an increase in interest rates is observed. Which causes price volatility in the bond market. Thus, the price of bonds falls. The Federal Reserve already hiked interest rates four times and three times in 2022 and 2023, respectively, the highest after 22 years.

2. Credit risk

Credit risk refers to the condition that a company might default. In such a situation, the investor will lose all the promised interest payout along with the principal. The only dependable option to cope with credit risk is credit rating. Agencies such as Moody’s or Fitch ratings are the most trustable credit rating agencies. Therefore, an investor can prevent credit risk by investing in a bond, rated good by credit rating agencies.

How to invest in fixed-income securities

It is possible to purchase bonds directly from the issuer. However, it is going to be a tough task. Similarly, purchasing bonds in the secondary market will not come alone but with high transaction costs and broker charges. Then what could be the best possible way to purchase bonds?

The easiest available option is none other than bond exchange-traded funds (ETFs) and Bond mutual funds.

Both exchange-traded funds and bond mutual funds work like a regular mutual fund. The mutual fund will use the pool of money to purchase different bonds or treasuries. Much like mutual funds, investors will get an options such as Balanced bonds, high-return bonds, etc. ETFs are more accessible and cost-friendly than bond mutual funds.

To Conclude

Fixed-income investments, which come in various forms, can offer a plethora of benefits over the equity market. It is also worth noting that fixed-income securities attract taxes just like equities do. Due to less volatility, the bond market will add a lot of investors in these recessionary times. New-age investors can focus more on equities but it is crucial to have a certain portion of the portfolio reserved for fixed-income investments such as treasuries or bonds.

Frequently Asked Questions (FAQs)