What Are Fixed-Income Securities?
A fixed-income security is an investment that provides a return through fixed periodic interest payments and the eventual return of principal at maturity. Unlike variable-income securities, where payments change based on an underlying measure, such as short-term interest rates, the returns of a fixed-income security are known.
Key Takeaways
- Fixed-Income securities provide investors with a stream of fixed periodic interest payments and the eventual return of principal at maturity.
- Bonds are the most common type of fixed-income security.
- Different bonds have different term lengths depending on how long the issuer wishes to borrow for.
- Ratings agencies assign ratings to a bond based upon the issuer's creditworthiness and financial situation.
- Fixed-income securities from the U.S. Treasury are backed by the full faith and credit of the United States government, making them very low-risk but relatively low-return investments.
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Understanding Fixed-Income Securities
Fixed-Income securities are debt instruments that pay a fixed amount of interest, in the form of coupon payments, to investors. The interest payments are commonly distributed semiannually, and the principal is returned to the investor at maturity. Bonds are the most common form of fixed-income securities.
A bond is an investment product corporations and governments issue to raise funds to finance projects and fund operations. Corporate and government bonds have various maturities and face values. The face value is the amount the investor will receive when the bond matures. Corporate and government bonds mostly trade over-the-counter (OTC) and not on exchanges. They are usually listed with $1,000 face values, also known as the par value.
Companies, governments, and other entities raise capital by issuing fixed-income products to investors.
Credit Rating of Fixed-Income Securities
Bonds are assigned different credit ratings based on the financial viability of the issuer. Credit ratings are part of a grading system performed by credit-rating agencies. These agencies measure the creditworthiness of corporate and government bonds and the entity's ability to repay these loans. Credit ratings are helpful to investors because they define the risks involved in investing.
Bonds can either be investment-grade or non-investment-grade bonds. Investment grade bonds are issued by stable companies with a low risk of default and, therefore, have lower interest rates than non-investment grade bonds. Non-investment grade bonds, also known as junk bonds or high-yield bonds, have lower credit ratings due to a probability of default by the issuer. Investors receive a higher interest rate from investing in junk bonds for assuming the higher risk of these debt securities.
Types of Fixed-Income Securities
Treasury Notes
Treasury notes (T-notes) are issued by the U.S. Treasury and are intermediate-term bonds that mature in 2, 3, 5, 7, or 10 years. T-Notes are issued in increments of $100 and pay semiannual interest payments at fixed coupon rates or interest rates. The interest payment and principal repayment of all Treasury marketable securities are backed by the full faith and credit of the U.S. government, which issues these bonds to fund itself.
Treasury Bond
The U.S. Treasury also issues Treasury bonds (T-bond) which mature in 20 or 30 years. Treasury bonds are also sold in $100 increments and are sold at auction on the Treasury Direct website.
Treasury Bills
Short-term fixed-income securities include Treasury bills. The T-bill has a term of 4, 8, 13, 17, 26, or 52 weeks and doesn't pay interest. Instead, investors buy the security at a lower price than its face value or a discount. When the bill matures, investors receive the face value amount of the discount note. The interest earned or return on the investment is the difference between the purchase price and the face value amount of the bill.
Municipal Bond
A municipal bond is issued by states, cities, and counties to fund capital projects, such as roads, schools, and hospitals, commonly sold with a $5,000 face value. The interest earned from these bonds is exempt from federal income tax. The interest earned on a "muni" bond may be exempt from state and local taxes if the investor resides in the state where the bond is issued. The muni bond has several maturity dates in which a portion of the principal comes due in intervals until the entire principal is repaid.
Certificate of Deposit
A bank issues a certificate of deposit (CD). In return for depositing money with the bank for a predetermined period, the bank pays interest to the account holder. CDs often have maturities of five years or less, but some can be for even longer terms. They typically pay lower rates than bonds, but higher rates than traditional savings accounts. A CD carries Federal Deposit Insurance Corporation (FDIC) insurance up to $250,000 per account holder.
Corporate Bonds
Corporate bonds are debt securities issued by companies to raise funds. Unlike company stocks, bond investors have no voting rights or equity in the company. Bonds are classified based on their maturity period. Short-term bonds are held for less than three years, medium-term for four to ten years, and long-term for more than ten years. Bonds are classified as investment or non-investment grade depending on the company's credit rating.
Preferred Stock
Companies issue preferred stock that provides investors with a fixed dividend, set as a dollar amount or percentage of share value on a predetermined schedule. Interest rates and inflation influence the price of preferred shares, and shares have higher yields than most bonds due to their longer duration.
Advantages and Disadvantages of Fixed-Income Securities
Advantages
Fixed-income securities provide steady interest income to investors, reduce risk in an investment portfolio and protect against volatility or fluctuations in the market. Equities are traditionally more volatile than bonds so investors may allocate a portion of their portfolios to fixed-income investments to reduce their risk level. Fixed-income securities are also available in mutual fundsand exchange-traded funds (ETFs).
The prices of bonds and fixed-income securities increase and decrease. Although the interest payments of fixed-income securities are steady, their prices are not guaranteed to remain stable throughout the life of the holding. If investors sell a fixed-income security before maturity, gains or losses are based on the difference between the purchase price and the sale price.
Besides the risk of price fluctuations, bonds also have the risk of a potential default. U.S. government bonds are considered incredibly low-risk as they are backed by the full faith and credit of the United States government.Corporate bonds depend on the financial viability of a company and have a higher risk of default than government bonds. However, corporate bonds have a good chance to be repaid if a company declares bankruptcy since bondholders will be repaid before common and even preferred stockholders.
Disadvantages
Fixed-income securities commonly have low returns and slow capital appreciation or price increases. This is the trade-off for lower risk. Their prices tend to decrease slower as well. The initial principal amount is often inaccessible, particularly with long-term bonds with maturities greater than ten years. However, the bond can be sold to get the investment back early, if the current market value is equal or greater to the amount invested.
Fixed-income securities provide a fixed interest payment regardless of where market interest rates move. An investor that purchased a bond paying 2% per year will lose out on income if market interest rates rise above that level and the investor's money is tied-up in the 2% bond. This is also what causes a decline in the market price of bonds. If rates rise above the bond's interest rate, its market value declines. Inflation may erode the return on fixed-rate securities if the inflation rate is higher than the interest rate of the fixed-income instrument.
All bonds have credit or default risk since the securities are tied to the issuer's financial viability. Investing in international bonds can increase the risk of default if the country is economically or politically unstable.
Pros
Fixed-income securities provide steady interest income to investors throughout the life of the bond
Fixed-income securities are rated by credit rating agencies
Fixed-income securities usually have less price volatility than stocks
U.S. Treasury fixed-income securities are backed by the full faith and credit of the United States government
Cons
The issuer can default on making the interest payments or paying back the principal
Fixed-income securities typically have a lower rate of return than many other investments including stocks
Inflation risk can be an issue if prices rise by a faster rate than the interest rate on the fixed-income security
Market interest rates may rise higher than the rate on a fixed-income security
Real-World Example
Treasury bonds are long-term bonds with a maturity of 20 or 30 years. T-Bonds provide semiannual interest payments and are sold in increments of $100. A 30-year Treasury bond was issued on March 15, 2024, with a rate of 4.250%. Investors are paid $4.25 per 100 dollars invested each year. The principal is repaid in 30 years.
A 10-year Treasury note was issued on March 15, 2024, with a rate of 4.000%. The note also pays semiannual interest payments at fixed coupon rates and is sold in $100 increments. Each note of $100 would pay $4.00 per year until maturity, and return the principal after 10 years.
How Can You Invest in Fixed Income Securities?
Investors can purchase U.S. government fixed-income instruments through TreasuryDirect or on the secondary market through a broker. Corporate bonds or bond funds can be purchased through a financial broker. Certificates of Deposit are purchased through financial brokers or banks.
What Are the Risks of Investing in Fixed Income Instruments?
Fixed income instruments require investors to commit their money for an extended period, sometimes up to thirty years. Although there is a way out: selling the bond. This can result in a gain or less depending on how its value has shifted. As interest rates change, a bond's market prices shifts. If interest rates rise, the bond's market price will decline, and if interest rates fall, the bond's market value will rise. In the case that interest rates rise, the investor is missing out on higher rates from newer bonds, and at the time they would lose money if they sold the bond. Inflation can also affect the market value of fixed-income securities as well as erode the real value of its yield.
What Does It Mean to Default on a Fixed-Income Security?
Default is the failure to make required interest or principal repayments on a debt, whether that debt is a loan or a security. Individuals, businesses, and even countries can default on their debt obligations.
The Bottom Line
A fixed-income security is an investment that provides a steady interest income stream for a certain period. Types include government bonds, corporate bonds, and certificates of deposit. There are also mutual funds and ETFs which hold a large number of bonds in one fund, allowing investors to easily diversify their fixed-income investments. Fixed-income securities are rated by credit agencies that assess the default risk for investors. These investments typically have a lower rate of return than stocks.
