Fixed income investing plays a vital role for investors seeking a balanced investment portfolio. Although many see fixed income investments as being less glamorous than the stock market, the predictability of investing in a bond or other fixed income security is useful. In particular, when you pay a fixed amount in exchange for periodic interest payments and the promise to receive your principal back at maturity, you can forecast your future cash flow exactly and can therefore structure your portfolio to meet your financial needs.
Even inexperienced investors can navigate the fixed income market and find investments that will meet their needs.
What is a fixed income investment?
Typical fixed income investments include bonds, bank certificates of deposit, and similar obligations. Fixed income almost always involves arrangements that resemble loans, in which a borrower accepts investors' money up front and promises to pay them back at a later date.
Most fixed income investments involve the borrower making interest payments to the investor at regular intervals. However, some fixed income investments are known as zero coupon securities, and they don't include interest payments. Instead, the borrower accepts a discounted amount up front and then pays a larger amount at maturity. For instance, for a five-year zero coupon bond with interest rates at roughly 2%, the investor might give the borrower $900 at the beginning of the period in exchange for a promise to receive $1,000 five years from now when the bond matures.
What risks do fixed income investments carry?
Most investors see fixed income investments as being less risky than stocks, and it's true that fixed income is much more predictable than stock investments. However, fixed income does have its own risks. They include:
- Default risk: If something happens to the borrower, then it might not be able to repay the loan, leaving you with a loss.
- Interest rate risk: If prevailing interest rates rise, then you'll be locked into a low-rate fixed income investment until it matures. Rising rates also typically cause the prices of fixed income investments on the secondary market to fall.
- Inflation risk: Fixed income involves trading money now for the promise of receiving money later. However, high inflation can erode the purchasing power of the money you get back from the borrower in the future. A few fixed income investments have provisions that allow for inflation-based adjustments, but most leave the investor exposed to inflation risk.
In addition, other specific risks can apply to certain fixed income securities. For example, some bonds include call provisions that allow the borrower to prepay the loan early. That might seem like a good thing for the investor, but borrowers typically exercise those provisions only when prevailing interest rates have fallen, and that can leave investors scurrying to find alternatives and often having to accept less income on a replacement investment.
Fixed income securities offer valuable diversification for investment portfolios that are heavy in stocks. Fixed income has its own risks, but most investors find it useful to have some balance between fixed income and other investments in their portfolios.
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