Fixed-income investments generally pay a fixed rate of return on a fixed schedule. Thus, the best example in investing is a bond, which will pay the investor a set amount of interest every six months and return an investor's principal upon maturity.
Here are some classic examples of fixed-income investments and the strategies some investors use to generate higher returns.
1. U.S. Treasuries
Issued by the federal government, U.S. Treasuries pay interest semiannually until the bond matures and the principal is repaid in full. The tenor of a U.S. Treasury bond can vary from as little as one month, known as a U.S. Treasury bill, all the way up to a 30-year U.S. Treasury bond. These are known as "risk-free" bonds, as the U.S government can theoretically always pay interest and principal by issuing new currency to do so. Thus, U.S. Treasuries offer the lowest return of any fixed-income investment. For individual investors, savings bonds may be a better alternative.
2. Money market funds
Money market funds invest in the short-term debt of the U.S. government and respected large companies. Generally, money market funds seek to invest in debt that matures in less than one year, thus providing safety from interest-rate fluctuations and reducing the risk that a borrower will default. When a company like Wal-Mart needs to finance payroll, it might borrow from money market funds for a period spanning less than one month, for example.
3. Investment-grade corporate bonds
Companies often need to borrow money for periods spanning years, rather than mere weeks or months. When they do, companies issue bonds that offer a stated rate of interest on a fixed schedule, typically paying interest semiannually. Investment-grade corporate bonds are issued by companies that have a BBB- or Baa3 rating or better from the big credit rating agencies. They typically yield slightly more than U.S. Treasuries of similar tenor but less than junk-rated corporate borrowers.
4. High-yield bonds (a.k.a. junk bonds)
Even the riskiest borrowers need money, too. Junk bonds are those issued by entities that have a credit rating of BB+/Ba1 or lower, or don't have a credit rating at all. These bonds are typically scheduled to pay interest semiannually and mature in only a few years. (Most junk-rated borrowers find it difficult to borrow for 10- or 20-year periods, because of the risk of default.)
5. Certificates of deposit
Banks need a steady source of deposits to fund loans, so they pay savers more interest when they agree to lock up their money for a longer period of time. Ranging from one month to five years, and occasionally seven years or more, certificates of deposit offer a low but safe return. Conveniently, the FDIC insures certificates of deposit for up to $250,000, making them one of the safest short-term investments.
6. Municipal bonds
Investors in high marginal tax brackets tend to invest in municipal bonds because the interest they pay is exempt from federal income tax. Municipal bonds, issued by local governments for periods that span months to 20 years or more, help fund infrastructure projects such as highway construction or water treatment plants.
Investors can employ a number of strategies to find the best balance of risk and reward in their fixed-income portfolios. Here are three common strategies investors use.
1. Laddering strategy
Investors who believe that rates will rise in the future often ladder their investments so that they don't miss out on rising interest rates. A common example is the CD ladder, in which an investor puts 20% of his or her money in five different CDs that will mature in one to five years. When the one-year CD matures, the principal can be rolled into a new five-year CD, and so on, thus continuing the ladder into the future.
2. Barbell strategy
A barbell strategy seeks to generate a higher yield on fixed-income investments by putting a small amount of capital in higher-risk investments. Thus, one might put 80% of his or her money in safer bonds that yield 2% and put the remaining 20% in junk bonds that yield 6%. The blended return of 2.8% is substantially higher than the 2% return of safer bonds, while putting only 20% of the investors' wealth at an increased risk of loss.
3. Rebalancing strategy
By far the most common approach, rebalancing happens on a set schedule, whereby investors sell their best-performing assets and buy more of the most beaten-down assets. An investor might put 60% of his or her wealth in stocks and 40% in bonds. After a year in which stocks rocket, the investor would sell some of his or her stocks to buy more bonds, thus returning to the 60/40 stock-and-bond allocation.
No matter the strategy, fixed-income investments deserve a spot in any portfolio. Historical evidence has shown that a diversified portfolio of stocks and bonds has generated excellent returns while reducing risk. Data from fund manager Vanguard shows that an 80/20 mix of stocks and fixed-income investments produced a 9.5% annualized return, only slightly lower than the 10.1% return of a portfolio of 100% stocks from 1926 to 2015.
Despite a slightly lower return, a diversified portfolio of stocks and fixed-income investments produced fewer losing years and lost substantially less value in the worst years for stocks, making it much easier for investors to avoid panic during the occasional periods when stock prices fall dramatically.
Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.