Fixed Income Investments: What They Are and How They Work

Investing

Jul 28

Whether used for income generation, capital preservation, or risk management, fixed income investments provide a structured and reliable option to help investors meet their long-term financial goals.

What is a fixed income investment?

A fixed income investment is a type of financial asset that provides predictable returns via regular interest payments over a set period of time. Unlike stocks, which can fluctuate in price based on market conditions, fixed income investments offer stability by paying a predetermined income (typically in the form of interest). Individuals and institutions looking to preserve capital, generate consistent cash flow, and/or reduce overall portfolio risk commonly turn to these types of investments.

Fixed income investments appeal to investors who prioritize steady income over the potential for higher (but more volatile) stock market returns, such as retired individuals or those nearing retirement. While these are generally considered lower risk than stocks, they aren’t entirely risk-free. Government-backed securities tend to have the lowest risk, whereas corporate debt may carry higher risk depending on the company's credit rating.

How fixed income investing works

Fixed income investments are essentially a loan; the investor is the lender, who (in this case) lends money to an issuer in exchange for regular interest payments over a predetermined period of time ending with the maturity date when the issuer repays the original amount (or principal) to the investor. Fixed income investments are sometimes held until maturity or traded on the secondary market.

For example, let’s say an investor purchases a $10,000 corporate bond with a coupon rate of 5%—meaning the bond pays 5% interest on the principal amount ($10,000) annually, giving the investor $500 each year. Over the life of the bond, the investor earns regular income via these interest payments with the original principal of $10,000 returned to the investor at maturity.

The core mechanism behind fixed income investing is the interest rate (i.e., the coupon rate) typically set when the investment is issued, determining how much the investor will receive in periodic payments. Some fixed income investments have fixed coupon rates—meaning interest payments remain constant—while others have variable rates that adjust per market conditions.

Interest rates and inflation play a significant role in the value of fixed income investments. When interest rates rise, the value of existing fixed income assets often declines because newer investments offer higher returns. Conversely, when rates fall, the value of existing fixed income investments increases to make them more attractive. Inflation can also impact purchasing power as fixed payments may not keep up with rising costs over time.

Credit risk also plays a role in how fixed income investing works. Issuers with strong financial health (e.g., governments or well-established corporation) generally offer lower yields due to a minimal risk of default. In contrast, issuers with weaker credit ratings may offer higher yields to compensate investors for taking on additional risk.

Types of fixed income investments

Fixed income investments come in many forms to give investors a range of options based on various factors such as credit quality, maturity length, and yield potential.

Government bonds

One of the most well-known types of fixed income investments is government securities issued by national governments to fund public projects and operations. U.S. Treasury securities are a primary example, with options including bills (short-term: less than one year), notes (medium-term: 2 to 10 years), and bonds (long-term: 20 to 30 years)—considered among the safest fixed income investments due to the government’s ability to raise funds via taxation. Other countries issue similar securities such as UK Gilts or German Bunds.

For investors seeking income with some protection against inflation, the U.S. government sells Treasury Inflation-Protected Securities (TIPS) that adjust their principal value based on inflation rates to ensure purchasing power is maintained over time.

Municipal bonds

Municipal bonds, another form of government-issued fixed income investment, are issued by governments at the state and local levels. These help fund infrastructure projects (e.g., roads, schools, and water systems) and often provide tax advantages to investors as interest earned is typically exempt from federal and, in some cases, state and local taxes.

Corporate bonds

Corporate bonds—issued by companies to raise capital for expansion, acquisitions, or operational funding—vary widely in risk, with investment-grade bonds issued by financially stable companies offering lower yields and speculative-grade (or high-yield) bonds providing higher returns to compensate for increased credit risk.

Certificates of deposit (CDs)

Banks and credit unions offer CDs as a type of fixed income investment whereby you agree to deposit a set amount of money over a specific period of time—ranging from a few months to several years—in exchange for a guaranteed interest rate. While CDs are considered low risk because they typically offer fixed returns and are insured by the FDIC, your money is locked in for the term of the CD and early withdrawals are often penalized.

How to invest in fixed income securities

Multiple ways to access these types of securities do indeed exist ranging from directly purchasing individual bonds to investing in diversified funds that provide exposure to a broad range of fixed income assets.

Government auctions and brokerage accounts

One of the most straightforward ways to do so is by purchasing individual bonds through government auctions/brokerage accounts or directly from issuers in the primary market. Investors who buy individual bonds typically hold them until maturity, collecting regular interest payments and receiving the principal back at the end of the term.

You can also buy and sell bonds on the secondary market, however, allowing investors to adjust their portfolios based on shifting interest rates or financial needs.

ETFs and mutual funds

For those seeking diversification, bond mutual funds and exchange-traded funds (ETFs) offer an alternative to individual bonds: pooling money from multiple investors to buy a range of fixed income securities and thus providing this instantly. The primary difference is that mutual funds typically feature active management whereas ETFs often track a bond index, meaning they’re not actively managed though often have lower costs and greater flexibility. Many retirement plans (e.g., 401(k)s and IRAs) offer bond funds as an investment option whereby individuals can allocate a portion of their portfolio to fixed income.

Bond ladders

A bond portfolio can also be structured into a bond ladder whereby an investor buys bonds with staggered maturities to manage interest rate risk and maintain consistent cash flow. In reinvesting proceeds from maturing bonds into new ones, investors can adjust to evolving market conditions while maintaining income.

Fixed income investment advantages

Predictable income

One of the biggest advantages of fixed income investing is in the name, synonymous with predictable income whereby investors receive regular interest payments as a reliable cash flow source.

Lower risk

Another key benefit is lower risk compared to stocks. While stock prices are known to fluctuate dramatically, fixed income securities are often less volatile as a safer investment option—particularly for those looking to preserve capital. Government bonds, specifically, are considered among the safest investments available as they’re backed by the creditworthiness of the issuing government.

Diversification

Fixed income investments also provide diversification, helping to balance a portfolio, and can act as a buffer against market downturns as bonds and other fixed income assets often perform differently from stocks.

Potential tax advantages

Various fixed income securities (e.g., municipal bonds), meanwhile, offer tax advantages; as interest earned on some municipal bonds is exempt from federal taxes (and in some cases state and local taxes), this is often beneficial for investors in higher tax brackets seeking ways to maximize after-tax income.

Fixed income investment risks

Despite many benefits, fixed income investments also have some drawbacks.

Interest rate risk

One major downside? Interest rate risk; when interest rates rise, the value of existing fixed income securities typically declines, often a concern for investors who may need to sell before maturity as they can face losses if their bonds are worth less than what they originally paid.

Inflation risk

Inflation erosion is another potential risk—with fixed income returns perhaps not keeping up with rising costs unless investors hold inflation-protected securities such as Treasury Inflation-Protected Securities (TIPS)—as is credit risk, particularly with corporate bonds and lower-rated debt.

Default risk

A risk of default also comes into play if an issuer faces financial trouble, meaning investors may not receive interest payments or lose their principal altogether; while government bonds tend to have lower credit risk, corporate and municipal bonds call for a careful evaluation of the issuer’s financial health.

Lower returns

Lastly, fixed income investments often offer lower returns compared to stocks.

The takeaway

Fixed income investments can provide stable income but aren’t without risk. As the right approach depends on various factors such as investment time horizon, risk tolerance, and income needs, this will indeed differ for everyone. Speak with your financial advisor to determine how to best incorporate fixed income investments into your portfolio.

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