Takeaways
- Fixed-income investments are debt securities that pay interest income to investors.
- Corporate bonds, TIPs, and Treasury bills are common fixed-income investments.
- Fixed-income investments tend to have lower rates of return than publicly traded stocks.
- Fixed-income investments have many risks like credit, interest rate, and inflation.
- Fixed-income investments pay back investors their principal investment at maturity, attracting investors who are focused on capital preservation.
What Is Fixed Income?
Fixed-income investing is an investment strategy focusing on financial products that generate interest income. Financial advisors and planners often include fixed-income investments in their portfolio construction because they are a crucial building block of a well-diversified portfolio.
Fixed-income investments are one of the seven asset classes. They attract both beginner investors and seasoned investors and can help investors generate a passive income stream or plan for retirement.
Fixed-income investment structures vary by the type of asset you are investing in. However, let’s look at a typical fixed-income instrument, such as a bond.
Bonds are loans that investors make to borrowers, corporations, and governments to finance product launches, growth plans, and more. In return for borrowing their capital, the bond issuer agrees to pay interest regularly and repay the original principal at maturity. This creates a predictable source of interest income and reliable returns for the bondholder.
Fixed-income securities are often viewed as having lower investment risk than publicly traded stocks because they provide regular interest income payments and the principal's return following the investment period's conclusion. With an investment in common stock, however, you can lose the whole value of your initial investment.
For a fixed-income investment, the level of investment risk fluctuates based on the creditworthiness of the issuer and the type of security. For instance, U.S. Treasury Bills (T-bills) are generally considered safer than corporate bonds because a corporation is more likely to default than the government. Any well-diversified portfolio has an allocation for fixed-income Investments because they provide remarkable stability and capital preservation.
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How to Invest in Fixed-Income
Investing in fixed-income products can be done through different avenues. You can invest through your online brokerage account, bank, or credit union. How you invest depends on your experience level, personal preference, financial goals, and risk tolerance.
One of the most common ways is to purchase bonds directly from issuers. You can buy U.S. Treasury Bills or bonds through U.S. government websites like TreasuryDirect.gov. Alternatively, if you want to avoid buying bonds directly, you can get bond exposure through bond funds.
Bond funds pool money from many investors who want to buy a pre-diversified portfolio of bonds. Portfolio managers who specialize in fixed-income investments actively manage these funds. These managers curate a mix of bonds projected to meet the fund's investment goals. Bond funds can provide diversification and low-cost professional management, making them an excellent option for retail investors.
Fixed-income ETFs, or exchange-traded funds, are also incredibly popular for fixed-income investing. These funds trade on major stock exchanges and are created to mimic the performance of other index funds or sector benchmarks. ETFs offer high liquidity, and since they are passively managed, they are also a highly cost-effective way to get exposure to a broad range of bonds.
Certificates of deposit, also known as CDs, are another fixed-income investment. They are typically offered by banks and credit unions and offer a fixed interest rate over a specified term. At the end of the term, the principal is returned with interest. They are FDIC-insured, which substantially lowers their overall risk.
How you invest in fixed-income products depends on what you are trying to optimize your portfolio for. There are many fixed-income products (more on this below), so you should select the best fit for your portfolio.
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Pros of Fixed Income
The lion's share of risks associated with fixed-income investments pertains to an investment structure. Here are some common drawbacks to investing in fixed-income securities
- Predictable Income: Whether you are trying to boost your income or live off a fixed investment principal, predictable income streams help almost anyone. These securities pay interest income, which is an attractive passive income stream.
- Capital Preservation: Because your investment principal is returned to you at the end of your investment term, preservation of capital remains a key draw for many investors. Fixed-income investments allow endowment funds to use the interest income to support their ongoing operations and retirees to live off interest income. (Read more about how annuities).
- Less Volatile: Fixed-income investments are typically viewed as safer than stocks because, in general, they are less volatile. They offer a preset cadence of investment returns that more conservative portfolios flock to gain.
- Diversification: New investors should start their investment portfolios on the right foot and remain focused on creating a diversified portfolio. Fixed-income investments provide access to rewards and risks that other investments don't.
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Cons of Fixed Income
The majority of risks associated with fixed-income investments pertains to an investment structure. Here are some common drawbacks to investing in fixed-income securities:
- Lower Returns: One big concern is the potential for lower returns than publicly traded companies on the Nasdaq or NYSE. Lower returns are a massive disadvantage for investors looking for significant investment growth. This lack of fast growth is why venture capital firms and hedge funds invest primarily in equities.
- Interest Rate Risk: Another major drawback is interest rate risk, associated with rising interest rates and decreasing the value of your fixed-income security.
- Inflation Risk: During rising prices, inflation risk is always at the top of investors' minds. Inflation risk is when the purchasing power of your interest payments diminishes because of rising inflation.
- Credit Risk: Finally, fixed-income investments can face credit risk, the risk of the issuer defaulting on their terms and not paying interest payments or your principal back. Credit risk is why corporations issuing junk bonds pay a higher interest rate than Aaa-rated corporate bonds, which are judged to be the highest quality corporate bonds with minimal.[1]
7 Types of Fixed Income Products
Fixed-income investment products vary widely, offering unique benefits, structures, and risks profiles. Here are seven common fixed-income investments that can fit into almost any portfolio:
1. Money Market Instruments
Money market instruments are short-term debt securities that will mature in one year or less. They are incredibly liquid and considered a safe way to preserve capital while generating a modest return.
Money market instruments are a blanket term that covers short-term investments in commercial paper, treasury bills, bank accounts, and more. These investments are used as safe places to park cash temporarily.
2. Certificate of Deposits
Certificates of Deposits (CDs) are time deposits, meaning when you purchase a CD, you agree to leave your money in the account for the duration of the deposit.
The terms can range from a few months to several years, and interest rates are fixed. The biggest downside to CDs is that accessing your money early might be penalized. (Read more about how to build a CD ladder.)
3. Treasury Notes
Treasury notes are medium-term debt securities issued solely by the US Treasury. They have maturities ranging from two to ten years and pay interest every six months.
The principal is repaid at maturity, and they are backed by the U.S. government, making them one of the safest investments possible.
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4. Treasury Bonds
Treasury bonds are long-term debt securities that mature in 20 to 30 years. Unlike treasury notes, treasury bonds pay interest every six months and are perfect for stable long-term income.
You can buy U.S. Treasury Bonds on TreasuryDirect.gov. They are also backed by the full faith and credit of the U.S. government, making them a haven for capital.
5. Treasury Inflation-Protected Securities
Treasury Inflation-Protected Securities (TIPS) are specifically designed to protect you from inflation. The principal value of TIPS will fluctuate with the consumer price index (CPI).
TIPS pay interest twice a year based on the adjusted principal. TIPS are ideal for investors looking to hedge fixed income against inflation.
6. Corporate Bond
Corporate bonds are debt securities issued by companies that need capital. They generally offer higher interest rates than government bonds, but they also have a higher risk of default since corporations enter bankruptcy daily.
Rating agencies like Moody's, Standard & Poor's, and Fitch rate corporate bonds based on their risk scale. Triple-A ratings are considered the highest-grade investment-grade securities. (Read more about how to build a bond ladder.)
7. Junk Bond
Junk bonds, also called "high-yield bonds," are issued by corporations with lower credit ratings, often below standard investment grade. These bonds offer higher interest rates to compensate investors willing to shoulder greater potential risk of default.
Understanding the various ways to invest in fixed income and the risks involved is critical for making informed investment decisions. Your investments should always align with your long-term financial goals and risk tolerance.
Smart Summary
Most investors entertain fixed-income investing. For beginner investors, investing in fixed-income securities can be an excellent method of stepping cautiously into the investing world. More experienced investors looking to grow their capital by investing in stocks often return to fixed-income investing to create a passive income strategy and maintain their net worth.
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(1) Moody’s. Rating Scale and Definitions. Last Accessed January 14, 2025.
