Fixed-income investments can be a great way to get almost-guaranteed regular income, as well as protect your capital. But like most financial investments, there is as much bad and inaccurate information out there as there is good and accurate. Depending on the fixed-income investments you're considering (or maybe disregarding), you may be acting on myths, and those myths could cost you money.
We asked three of our contributing writers to discuss some of the more glaring myths out there. Here's what they had to say:
Dan Caplinger: There's a strong sense in the investing community that fixed-income investments never have any opportunity for growth. That's typically the case for traditional bonds, which only give investors the right to receive their principal back at maturity. Yet there's a host of other fixed-income investments that can grow.
For instance, real-estate investment trusts often have their value tied to the state of the real-estate market, and changes in property valuation can affect net asset value independent of their income payouts. Similarly, master limited partnerships and royalty trusts make payouts based on the price of the commodities they produce, as well as the amount of production they're able to generate from their business operations. Efforts to streamline operations can improve efficiency, and acquisitions can grow a business beyond its initial scope, and cause prices to rise accordingly.
Even among bonds, some growth potential exists. Convertible bonds come with an equity component, allowing bondholders to convert bonds to shares of stock under certain conditions. Accordingly, convertible bonds can grow sharply if the underlying stock performs well. All told, fixed income isn't a huge haven of growth, but there are ways for growth investors to carve out portions of the fixed-income market that meet their needs.
Eric Volkman: Certificates of deposit have often been considered safe investment alternatives to the "wilder" asset classes such as stocks. Some like them because they're easy to understand and almost effortless to buy. A CD, available at almost any bank, produces a fixed return over a certain period of time. What's better than guaranteed income?
In the case of CDs, that income isn't guaranteed at all. With any investment, you have to consider the real rate of return. This is simply the income produced by an asset minus the rate of inflation. So, for example, if you have a bond that pays a 2% coupon, and you hold it for a year during which inflation has risen 3%, in "real" terms you've lost 1% of your investment. Inflation has eaten away at the gain.
Inflation is minimal these days... but unfortunately, CDs are pegged to interest rates, so their nominal returns are likewise skinny. In fact, a recent study by Putnam investments found that real returns for CDs have been in negative territory every year from 2009 to 2014, at rates ranging from 0.2% to 2.5%. So much for safety.
Jason Hall: Bonds are widely seen as one of the safest ways to invest. But while that may be true when it comes to capital preservation, there are three very real risks to bond investing that you absolutely need to be aware of.
- The first is the risk that Eric touched on in his conversation about CDs: If the interest payments from the bond are less than inflation during the same period, you lose spending power. You may not lose "actual" dollars, but the dollars you have at the end won't go as far as when you started.
- Second, bond prices do fluctuate, moving up and down with the current interest rate. If you own a 10-year bond, but want to sell it early on the secondary market, you won't get par value for your bond if the rate it pays is less than the currently available rate. On the other hand, if your bond pays a higher yield, you'll be able to get a premium for it.
- Third, and maybe most important, are bond funds. If your bond investments are in bond funds, you can definitely lose money, especially in a rising rate environment like we are very likely to be entering into. This is because the bonds owned by the fund will fluctuate in value vis-a-vis interest rates; higher rates push bond values down, while lower rates push them up.
All fixed-income investments are not created equally
As the examples above show, all fixed-income investments aren't the same, and there is risk and opportunity with each that you need to understand. If you're looking for a fixed-income investment, be sure you consider your goals and time frame, and invest in the right kind of fixed-income investment.