Would you rather be paid a regular, fixed salary where you always know what to expect when it comes to your money? Or, would you prefer to receive more erratic payments that can fluctuate up and down, leaving your income stream unpredictable? The latter may have potential for greater payments, but the former offers consistency and stability. This is a bit how fixed-income securities and typical equity securities differ.
While both types of investments can play a significant role in your portfolio, fixed-income securities tend to take a backseat to equities. So, let’s take a look at this investment class and discuss why they’re an important asset for all investors to consider.
What is a fixed-income security?
A fixed-income security is a type of investment that pays periodic, fixed payments in the form of interest (sometimes referred to as coupons) or dividends, and many repay the original principal at a predetermined date (known as maturity). These investments are generally considered lower risk than typical equity securities (like common stock), and in return for greater stability, they tend to offer more modest returns.
What investments are considered fixed-income?
Bonds are the most common type of fixed-income security. Other kinds of fixed-income securities are money market funds and preferred stock shares.
Bonds are a form of debt security in which you lend the issuer (typically the government or a corporation) money in exchange for regular interest payments. Common types of bonds include:
- Treasury securities: Issued by the U.S. Treasury, Treasury bills (T-Bills), Treasury notes (T-Notes), and Treasury bonds (T-Bonds) are used to fund various projects and endeavors of the federal government. Because they’re backed by the federal government, these bonds are considered the lowest risk and have almost zero chance of default.
- Municipal bonds: A.k.a. “munis,” these bonds are issued by states, cities, counties, and other non-federal government entities to raise money for all kinds of public improvement projects.
- Corporate bonds: Companies issue corporate bonds to fund expensive undertakings like an expansion or the purchase of new facilities. Because they don’t have the backing of the “full faith and credit” of the U.S. government, these bonds can have a relatively higher risk of default than others.
Issued by companies, preferred stocks or shares are a type of security that pays dividends to preferred shareholders. Preferred shareholders have higher claim to dividends than common stockholders. Dividends are paid on a predetermined schedule — typically monthly or quarterly — and are a percentage of the share value.
What are benefits of investing in fixed-income securities?
Investing in fixed-income securities can be beneficial to your portfolio in a number of ways. They can provide a steady, predictable income stream through regular interest payments. And they’re a useful tool to diversify your portfolio and reduce overall risk. Because bonds and other fixed-income securities aren’t as sensitive to market ups and downs as stocks, they can help provide balance and protection against market volatility.
Fixed-income securities also offer greater protection of principal than typical equities. If you hold your fixed-income security until maturity, you will ordinarily receive the full face value you paid originally (keep in mind, though, that while it’s typically unlikely, it is possible for bonds to default).
What are risks of investing in fixed-income securities?
All investments have risk, including bonds and other fixed-income securities. As we’ve mentioned, when it comes to bonds, there is a chance of default. This is most common with corporate bonds. It’s a good idea to check a bond’s credit rating before investing to get an idea of how likely the issuer is to pay the coupon over time and the principal at maturity.
When you invest in fixed-income securities, you also face interest rate risk and inflation risk. Because your interest rate is fixed, you could receive a lower rate than the overall market, for example, if interest rates rise after you purchase the bond. Inflation is always a risk when it comes to fixed-income instruments since your payments will not change regardless of the actual buying power of your dollars.
Finally, your money can be tied up in a fixed-income security for many years, meaning you won’t have easy access to that cash. While you can sell bonds before maturity, doing so could result in capital loss if the bond’s price decreased since you bought it.
Fixed-income securities are a safer route for many investors
With generally low risk and predictable returns, fixed-income securities can be a smart addition to any portfolio — whether you primarily use them to create a stream of investment income or as protection against market volatility.
Investing in bonds is easy with Ally Invest.